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.
Tuesday, October 14, 2008
Thursday, October 2, 2008
Chapter 5: The Defensive Investor and Common Stocks
Rules for the defensive investor:
1. In order to have diversification, an investor should have 10 to 30 different stocks.
2. The underlying company should be large and managed conservatively. "Large" can be defined as market capitalization of 10B$ in today's market.
3. The underlying company should have a long track of paying dividends.
4. Maintain margin of safety on the purchase price of a stock. As an example, set a limit of 25 times average earnings over the past 7 years and less than 20 times of the earnings in the last 12 months.
By reading point #4 above, by definition, a growth stock is expected to continue with increase in per-share earnings in the future and this increase is already factored in the stock price. Therefore, there is a speculative element in buying growth stocks.
Concept of "risk"
Risk and safety can be applied in different context when it comes to stocks and bonds. When a bond defaults on its interest and principal payments, it has deemed unsafe. Likewise, when there is a reduction of dividend on an underlying stock, that stock is deemed unsafe since there were expectation of dividend payments.
The concept of risk applies to a decline in the stock price even though the decline may be temporary. But this may not be a true risk in the general sense of the word. True risk occurs when there is a possibility of losing money either through an actual sale or a deterioration in the underlying business.
1. In order to have diversification, an investor should have 10 to 30 different stocks.
2. The underlying company should be large and managed conservatively. "Large" can be defined as market capitalization of 10B$ in today's market.
3. The underlying company should have a long track of paying dividends.
4. Maintain margin of safety on the purchase price of a stock. As an example, set a limit of 25 times average earnings over the past 7 years and less than 20 times of the earnings in the last 12 months.
By reading point #4 above, by definition, a growth stock is expected to continue with increase in per-share earnings in the future and this increase is already factored in the stock price. Therefore, there is a speculative element in buying growth stocks.
Concept of "risk"
Risk and safety can be applied in different context when it comes to stocks and bonds. When a bond defaults on its interest and principal payments, it has deemed unsafe. Likewise, when there is a reduction of dividend on an underlying stock, that stock is deemed unsafe since there were expectation of dividend payments.
The concept of risk applies to a decline in the stock price even though the decline may be temporary. But this may not be a true risk in the general sense of the word. True risk occurs when there is a possibility of losing money either through an actual sale or a deterioration in the underlying business.
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