Tuesday, October 14, 2008

Chapter 6: Portfolio policy for the enterprising investor: negative approach

Both aggressive and defensive investors should start from the same foundation i.e. high-grade bonds and high-grade stocks which have been bought with margin of safety. With enough business justification, an aggressive investor can also venture into other kinds of investments. The selection of the investment can be based on competence, interests and preferences.
Having said that, an aggressive investor should avoid inferior bonds, foreign bonds, new stocks (IPOs) and convertibles. Second-grade bonds, even with discounted prices, compete with reliable stocks. Thus, enterprising investors might as well invest in high-grade bonds selling at a discount. This way, he will have both income and a high probability for price appreciation. Just to give an example on how lethal second-grade bonds can be, Ben Graham mentions ten income bonds lost a third of its value in 1947 even though the underlying businesses had better earnings in the same year. Thus it is never a good idea to buy second-grade bonds at par just to earn a slightly higher interest when there is a possibility of complete wipe-out of the principal. However, it might make sense to buy the bonds under par.

Investors should not be concerned with high-grade foreign government bonds such as from Australia. However, during times of trouble, an investor often has no legal means of enforcing claims.

Investors should be cautious of new issues as they are sold in optimum conditions for the underlying businesses. There is also a special "salesmanship"
that goes with the new issues.

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