100*—the chances are very great that at some future time the holder will see much lower quotations. For when bad business comes, or just a bad market, issues of this kind prove highly sus- ceptible to severe sinking spells; often interest or dividends are suspended or at least endangered, and frequently there is a pro- nounced price weakness even though the operating results are not at all bad. As a specific illustration of this characteristic of second-quality senior issues, let us summarize the price behavior of a group of ten railroad income bonds in 1946–47. These comprise all of those which sold at 96 or more in 1946, their high prices averaging 102 1 ⁄2. By the following year the group had registered low prices averaging only 68, a loss of one-third of the market value in a very short time. Peculiarly enough, the railroads of the country were showing much better earnings in 1947 than in 1946; hence the drastic price decline ran counter to the business picture and was a reflection of the selloff in the general market. But it should be pointed out that the shrinkage in these income bonds was proportionately larger than that in the common stocks in the Dow Jones industrial list (about 23%). Obviously the purchaser of these bonds at a cost above 100 could not have expected to participate to any extent in a further rise in the securities market. The only attractive feature was the income yield, averaging about 4.25% (against 2.50% for first- grade bonds, an advantage of 1.75% in annual income). Yet the sequel showed all too soon and too plainly that for the minor advantage in annual income the buyer of these second-grade bonds was risking the loss of a substantial part of his principal. The above example permits us to pay our respects to the popu- lar fallacy that goes under the sobriquet of a “businessman’s investment.” That involves the purchase of a security showing a larger yield than is obtainable on a high-grade issue and carrying a correspondingly greater risk. It is bad business to accept an 136 The Intelligent Investor * Bond prices are quoted in percentages of “par value,” or 100. A bond priced at “85” is selling at 85% of its principal value; a bond originally offered for $10,000, but now selling at 85, will cost $8,500. When bonds sell below 100, they are called “discount” bonds; above 100, they become “premium” bonds. acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income. If you are willing to assume some risk you should be certain that you can realize a really substantial gain in principal value if things go well. Hence a second-grade 5.5 or 6% bond selling at par is almost always a bad purchase. The same issue at 70 might make more sense—and if you are patient you will probably be able to buy it at that level. Second-grade bonds and preferred stocks possess two contra- dictory attributes which the intelligent investor must bear clearly in mind. Nearly all suffer severe sinking spells in bad markets. On the other hand, a large proportion recover their position when favorable conditions return, and these ultimately “work out all right.” This is true even of (cumulative) preferred stocks that fail to pay dividends for many years. There were a number of such issues in the early 1940s, as a consequence of the long depression of the 1930s. During the postwar boom period of 1945–1947 many of these large accumulations were paid off either in cash or in new securities, and the principal was often discharged as well. As a result, large profits were made by people who, a few years previ- ously, had bought these issues when they were friendless and sold at low prices. 2 It may well be true that, in an overall accounting, the higher yields obtainable on second-grade senior issues will prove to have offset those principal losses that were irrecoverable. In other words, an investor who bought all such issues at their offering prices might conceivably fare as well, in the long run, as one who limited himself to first-quality securities; or even somewhat better. 3 But for practical purposes the question is largely irrelevant. Regardless of the outcome, the buyer of second-grade issues at full prices will be worried and discommoded when their price declines precipitately. Furthermore, he cannot buy enough issues to assure an “average” result, nor is he in a position to set aside a portion of his larger income to offset or “amortize” those principal losses which prove to be permanent. Finally, it is mere common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market. Portfolio Policy for the Enterprising Investor: Negative Approach 137 Foreign Government Bonds All investors with even small experience know that foreign bonds, as a whole, have had a bad investment history since 1914. This was inevitable in the light of two world wars and an interven- ing world depression of unexampled depth. Yet every few years market conditions are sufficiently favorable to permit the sale of some new foreign issues at a price of about par. This phenomenon tells us a good deal about the working of the average investor’s mind—and not only in the field of bonds. We have no concrete reason to be concerned about the future his- tory of well-regarded foreign bonds such as those of Australia or Norway. But we do know that, if and when trouble should come, the owner of foreign obligations has no legal or other means of enforcing his claim. Those who bought Republic of Cuba 4 1 ⁄2s as high as 117 in 1953 saw them default their interest and then sell as low as 20 cents on the dollar in 1963. The New York Stock Exchange bond list in that year also included Belgian Congo 5 1 ⁄4s at 36, Greek 7s at 30, and various issues of Poland as low as 7. How many readers have any idea of the repeated vicissitudes of the 8% bonds of Czechoslovakia, since they were first offered in this coun- try in 1922 at 96 1 ⁄2? They advanced to 112 in 1928, declined to 67 3 ⁄4 in 1932, recovered to 106 in 1936, collapsed to 6 in 1939, recovered (unbelievably) to 117 in 1946, fell promptly to 35 in 1948, and sold as low as 8 in 1970! Years ago an argument of sorts was made for the purchase of foreign bonds here on the grounds that a rich creditor nation such as ours was under moral obligation to lend abroad. Time, which brings so many revenges, now finds us dealing with an intractable balance-of-payments problem of our own, part of which is ascrib- able to the large-scale purchase of foreign bonds by American investors seeking a small advantage in yield. For many years past we have questioned the inherent attractiveness of such invest- ments from the standpoint of the buyer; perhaps we should add now that the latter would benefit both his country and himself if he declined these opportunities. 138 The Intelligent Investor New Issues Generally It might seem ill-advised to attempt any broad statements about new issues as a class, since they cover the widest possible range of quality and attractiveness. Certainly there will be exceptions to any suggested rule. Our one recommendation is that all investors should be wary of new issues—which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance.* The second is that most new issues are sold under “favorable market conditions”— which means favorable for the seller and consequently less favor- able for the buyer.† The effect of these considerations becomes steadily more impor- tant as we go down the scale from the highest-quality bonds through second-grade senior issues to common-stock flotations at the bottom. A tremendous amount of financing, consisting of the repayment of existing bonds at call price and their replacement by new issues with lower coupons, was done in the past. Most of this was in the category of high-grade bonds and preferred stocks. The buyers were largely financial institutions, amply qualified to pro- tect their interests. Hence these offerings were carefully priced to Portfolio Policy for the Enterprising Investor: Negative Approach 139 * New issues of common stock—initial public offerings or IPOs—normally are sold with an “underwriting discount” (a built-in commission) of 7%. By con- trast, the buyer’s commission on older shares of common stock typically ranges below 4%. Whenever Wall Street makes roughly twice as much for selling something new as it does for selling something old, the new will get the harder sell. † Recently, finance professors Owen Lamont of the University of Chicago and Paul Schultz of the University of Notre Dame have shown that corpora- tions choose to offer new shares to the public when the stock market is near a peak. For technical discussion of these issues, see Lamont’s “Evaluating Value Weighting: Corporate Events and Market Timing” and Schultz’s “Pseudo Market Timing and the Long-Run Performance of IPOs” at http:// papers.ssrn.com. meet the going rate for comparable issues, and high-powered salesmanship had little effect on the outcome. As interest rates fell lower and lower the buyers finally came to pay too high a price for these issues, and many of them later declined appreciably in the market. This is one aspect of the general tendency to sell new secu- rities of all types when conditions are most favorable to the issuer; but in the case of first-quality issues the ill effects to the purchaser are likely to be unpleasant rather than serious. The situation proves somewhat different when we study the lower-grade bonds and preferred stocks sold during the 1945–46 and 1960–61 periods. Here the effect of the selling effort is more apparent, because most of these issues were probably placed with individual and inexpert investors. It was characteristic of these offerings that they did not make an adequate showing when judged by the performance of the companies over a sufficient num- ber of years. They did look safe enough, for the most part, if it could be assumed that the recent earnings would continue without a serious setback. The investment bankers who brought out these issues presumably accepted this assumption, and their salesmen had little difficulty in persuading themselves and their customers to a like effect. Nevertheless it was an unsound approach to invest- ment, and one likely to prove costly. Bull-market periods are usually characterized by the transfor- mation of a large number of privately owned businesses into com- panies with quoted shares. This was the case in 1945–46 and again beginning in 1960. The process then reached extraordinary propor- tions until brought to a catastrophic close in May 1962. After the usual “swearing-off” period of several years the whole tragicom- edy was repeated, step by step, in 1967–1969.* 140 The Intelligent Investor * In the two years from June 1960, through May 1962, more than 850 com- panies sold their stock to the public for the first time—an average of more than one per day. In late 1967 the IPO market heated up again; in 1969 an aston- ishing 781 new stocks were born. That oversupply helped create the bear markets of 1969 and 1973–1974. In 1974 the IPO market was so dead that only nine new stocks were created all year; 1975 saw only 14 stocks born. That undersupply, in turn, helped feed the bull market of the 1980s, when roughly 4,000 new stocks flooded the market—helping to trigger the over- New Common-Stock Offerings The following paragraphs are reproduced unchanged from the 1959 edition, with comment added: Common-stock financing takes two different forms. In the case of companies already listed, additional shares are offered pro rata to the existing stockholders. The subscription price is set below the current market, and the “rights” to subscribe have an initial money value.* The sale of the new shares is almost always under- written by one or more investment banking houses, but it is the general hope and expectation that all the new shares will be taken by the exercise of the subscription rights. Thus the sale of addi- tional common stock of listed companies does not ordinarily call for active selling effort on the part of distributing firms. The second type is the placement with the public of common stock of what were formerly privately owned enterprises. Most of this stock is sold for the account of the controlling interests to enable them to cash in on a favorable market and to diversify their Portfolio Policy for the Enterprising Investor: Negative Approach 141 enthusiasm that led to the 1987 crash. Then the cycle swung the other way again as IPOs dried up in 1988–1990. That shortage contributed to the bull market of the 1990s—and, right on cue, Wall Street got back into the busi- ness of creating new stocks, cranking out nearly 5,000 IPOs. Then, after the bubble burst in 2000, only 88 IPOs were issued in 2001—the lowest annual total since 1979. In every case, the public has gotten burned on IPOs, has stayed away for at least two years, but has always returned for another scald- ing. For as long as stock markets have existed, investors have gone through this manic-depressive cycle. In America’s first great IPO boom, back in 1825, a man was said to have been squeezed to death in the stampede of specu- lators trying to buy shares in the new Bank of Southwark; the wealthiest buy- ers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value. * Here Graham is describing rights offerings, in which investors who already own a stock are asked to pony up even more money to maintain the same proportional interest in the company. This form of financing, still widespread in Europe, has become rare in the United States, except among closed-end funds. own finances. (When new money is raised for the business it comes often via the sale of preferred stock, as previously noted.) This activity follows a well-defined pattern, which by the nature of the security markets must bring many losses and disappointments to the public. The dangers arise both from the character of the businesses that are thus financed and from the market conditions that make the financing possible. In the early part of the century a large proportion of our leading companies were introduced to public trading. As time went on, the number of enterprises of first rank that remained closely held steadily diminished; hence original common-stock flotations have tended to be concentrated more and more on relatively small con- cerns. By an unfortunate correlation, during the same period the stock-buying public has been developing an ingrained preference for the major companies and a similar prejudice against the minor ones. This prejudice, like many others, tends to become weaker as bull markets are built up; the large and quick profits shown by common stocks as a whole are sufficient to dull the public’s critical faculty, just as they sharpen its acquisitive instinct. During these periods, also, quite a number of privately owned concerns can be found that are enjoying excellent results—although most of these would not present too impressive a record if the figures were car- ried back, say, ten years or more. When these factors are put together the following consequences emerge: Somewhere in the middle of the bull market the first common-stock flotations make their appearance. These are priced not unattractively, and some large profits are made by the buyers of the early issues. As the market rise continues, this brand of financing grows more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium-sized companies with a long market history. (It should be added that very little of this common-stock financing is ordinarily done by banking houses of prime size and reputation.)* 142 The Intelligent Investor * In Graham’s day, the most prestigious investment banks generally steered clear of the IPO business, which was regarded as an undignified exploita- The heedlessness of the public and the willingness of selling organizations to sell whatever may be profitably sold can have only one result—price collapse. In many cases the new issues lose 75% and more of their offering price. The situation is worsened by the aforementioned fact that, at bottom, the public has a real aver- sion to the very kind of small issue that it bought so readily in its careless moments. Many of these issues fall, proportionately, as much below their true value as they formerly sold above it. An elementary requirement for the intelligent investor is an abil- ity to resist the blandishments of salesmen offering new common- stock issues during bull markets. Even if one or two can be found that can pass severe tests of quality and value, it is probably bad pol- icy to get mixed up in this sort of business. Of course the salesman will point to many such issues which have had good-sized market advances—including some that go up spectacularly the very day they are sold. But all this is part of the speculative atmosphere. It is easy money. For every dollar you make in this way you will be lucky if you end up by losing only two. Some of these issues may prove excellent buys—a few years later, when nobody wants them and they can be had at a small fraction of their true worth. In the 1965 edition we continued our discussion of this subject as follows: While the broader aspects of the stock market’s behavior since 1949 have not lent themselves well to analysis based on long expe- rience, the development of new common-stock flotations pro- ceeded exactly in accordance with ancient prescription. It is doubtful whether we ever before had so many new issues offered, of such low quality, and with such extreme price collapses, as we Portfolio Policy for the Enterprising Investor: Negative Approach 143 tion of naïve investors. By the peak of the IPO boom in late 1999 and early 2000, however, Wall Street’s biggest investment banks had jumped in with both feet. Venerable firms cast off their traditional prudence and behaved like drunken mud wrestlers, scrambling to foist ludicrously overvalued stocks on a desperately eager public. Graham’s description of how the IPO process works is a classic that should be required reading in investment- banking ethics classes, if there are any. experienced in 1960–1962. 4 The ability of the stock market as a whole to disengage itself rapidly from that disaster is indeed an extraordinary phenomenon, bringing back long-buried memories of the similar invulnerability it showed to the great Florida real- estate collapse in 1925. Must there be a return of the new-stock-offering madness before the present bull market can come to its definitive close? Who knows? But we do know that an intelligent investor will not forget what happened in 1962 and will let others make the next batch of quick profits in this area and experience the consequent harrowing losses. We followed these paragraphs in the 1965 edition by citing “A Horrible Example,” namely, the sale of stock of Aetna Maintenance Co. at $9 in November 1961. In typical fashion the shares promptly advanced to $15; the next year they fell to 2 3 ⁄8, and in 1964 to 7 ⁄8. The later history of this company was on the extraordinary side, and illustrates some of the strange metamorphoses that have taken place in American business, great and small, in recent years. The curious reader will find the older and newer history of this enter- prise in Appendix 5. It is by no means difficult to provide even more harrowing examples taken from the more recent version of “the same old story,” which covered the years 1967–1970. Nothing could be more pat to our purpose than the case of AAA Enterprises, which hap- pens to be the first company then listed in Standard & Poor’s Stock Guide. The shares were sold to the public at $14 in 1968, promptly advanced to 28, but in early 1971 were quoted at a dismal 25¢. (Even this price represented a gross overvaluation of the enter- prise, since it had just entered the bankruptcy court in a hopeless condition.) There is so much to be learned, and such important warnings to be gleaned, from the story of this flotation that we have reserved it for detailed treatment below, in Chapter 17. 144 The Intelligent Investor COMMENTARY ON CHAPTER 6 The punches you miss are the ones that wear you out. —Boxing trainer Angelo Dundee For the aggressive as well as the defensive investor, what you don’t do is as important to your success as what you do. In this chapter, Graham lists his “don’ts” for aggressive investors. Here is a list for today. JUNKYARD DOGS? High-yield bonds—which Graham calls “second-grade” or “lower- grade” and today are called “junk bonds”—get a brisk thumbs-down from Graham. In his day, it was too costly and cumbersome for an indi- vidual investor to diversify away the risks of default. 1 (To learn how bad a default can be, and how carelessly even “sophisticated” profes- sional bond investors can buy into one, see the sidebar on p. 146.) Today, however, more than 130 mutual funds specialize in junk bonds. These funds buy junk by the cartload; they hold dozens of different bonds. That mitigates Graham’s complaints about the difficulty of diversifying. (However, his bias against high-yield preferred stock remains valid, since there remains no cheap and widely available way to spread their risks.) Since 1978, an annual average of 4.4% of the junk-bond market has gone into default—but, even after those defaults, junk bonds have 145 1 In the early 1970s, when Graham wrote, there were fewer than a dozen junk-bond funds, nearly all of which charged sales commissions of up to 8.5%; some even made investors pay a fee for the privilege of reinvesting their monthly dividends back into the fund. . years. There were a number of such issues in the early 1940s, as a consequence of the long depression of the 1930s. During the postwar boom period of 1945–1947 many of these large accumulations. and consequently less favor- able for the buyer.† The effect of these considerations becomes steadily more impor- tant as we go down the scale from the highest-quality bonds through second-grade. proportionately larger than that in the common stocks in the Dow Jones industrial list (about 23%). Obviously the purchaser of these bonds at a cost above 100 could not have expected to participate