3s, due 2047-originally a 150 year maturity!-long a typical Baarated bond.) Because of their inverse relationship the low yields correspond to the high prices and vice versa. The decline in the Northern The Investor and Market Fluctuations
- Graham has much more to say on what is now known as “corporate governance.” See the commentary on Chapter 19.Pacific 3s in 1940 represented mainly doubts as to the safety of the
issue. It is extraordinary that the price recovered to an all time high in the next few years, and then lost two thirds of its price chiefly because of the rise in general interest rates. There have been startling variations, as well, in the price of even the highest grade bonds in the past forty years.
Note that bond prices do not fluctuate in the same (inverse) proportion as the calculated yields, because their fixed maturity value of 100% exerts a moderating influence. However, for very long maturities, as in our Northern Pacific example, prices and yields change at close to the same rate.
Since 1964 record movements in both directions have taken place in the high grade bond market. Taking “prime municipals” (taxfree) as an example, their yield more than doubled, from 3.2% in January 1965 to 7% in June 1970. Their price index declined, correspondingly, from 110.8 to 67.5. In mid 1970 the yields on highgrade long term bonds were higher than at any time in the nearly 200 years of this country’s economic history.* Twenty five years earlier, just before our protracted bull market began, bond yields were at their lowest point in history; long term municipals returned as little as 1%, and industrials gave 2.40% compared with the ?2 to 5% formerly considered “normal.” Those of us with a long experience on Wall Street had seen Newton’s law of “action and reaction, equal and opposite” work itself out repeatedly in the stock market-the most noteworthy example being the rise in the DJIA from 64 in 1921 to 381 in 1929, followed by a record collapse to 41 in 1932. But this time the widest pendulum swings took place in the usually staid and slow moving array of high grade bond prices and yields.
- Recently, finance professors Owen Lamont of the University of Chicago
and Paul Schultz of the University of Notre Dame have shown that corporations 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 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 securities 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
September 3rd, 2009 — Investment Strategies
138 The Intelligent InvestorNew 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 favorable for the buyer.? The effect of these considerations becomes steadily more important 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 protect their interests. Hence these offerings were carefully priced to Portfolio Policy for the Enterprising Investor: Negative Approach
- New issues of common stock-initial public offerings or IPOs-normally are
sold with an “underwriting discount” (a built in commission) of 7%. By contrast, 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.
September 3rd, 2009 — Investment Strategies
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.
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 137Foreign Government Bonds All investors with even small experience know that foreign bonds, as a whole, have had a bad investment history since 1914.
September 3rd, 2009 — Investment Strategies
Throughout this article we refer to the possibility that any welldefined and protracted market situation of the past may return in the future. Hence we should consider what policy the aggressive investor might have to choose in the bond field if prices and yields of high grade issues should return to former normals. For this reason we shall reprint here our observations on that point made in the 1965 edition, when high grade bonds yielded only ?2%.
Something should be said now about investing in second grade issues, which can readily be found to yield any specified return up to 8% or more. The main difference between first and secondgrade bonds is usually found in the number of times the interest charges have been covered by earnings. Example: In early Chicago, Milwaukee, St. Paul and Pacific 5% income debenture bonds, at 68, yielded 7.35%. But the total interest charges of the road, before income taxes, were earned only 1.5 times in 1963, against our requirement of 5 times for a well protected railroad issue.
Many investors buy securities of this kind because they “need income” and cannot get along with the meager return offered by top grade issues. Experience clearly shows that it is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive.* (Here the word “merely” implies that the issue is not selling at a large discount and thus does not offer an opportunity for a substantial gain in principal value.) Where such securities are bought at full prices-that is, not many points under Portfolio Policy for the Enterprising Investor: Negative Approach
- For a recent example that painfully reinforces Graham’s point, see p.
below.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 susceptible to severe sinking spells; often interest or dividends are suspended or at least endangered, and frequently there is a pronounced price weakness even though the operating results are not at all bad.
September 3rd, 2009 — Investment Strategies
Better yet, your steady buying at lower prices would build the base for an explosive recovery when the market rebounds.
Source: The Vanguard GroupCHAPTER
Portfolio Policy for the Enterprising
Investor: Negative Approach The “aggressive” investor should start from the same base as the defensive investor, namely, a division of his funds between highgrade bonds and high grade common stocks bought at reasonable prices.* He will be prepared to branch out into other kinds of security commitments, but in each case he will want a well reasoned justification for the departure. There is a difficulty in discussing this topic in orderly fashion, because there is no single or ideal pattern for aggressive operations. The field of choice is wide; the selection should depend not only on the individual’s competence and equipment but perhaps equally well upon his interests and preferences.
The most useful generalizations for the enterprising investor are of a negative sort. Let him leave high grade preferred stocks to corporate buyers. Let him also avoid inferior types of bonds and preferred stocks unless they can be bought at bargain levels-which means ordinarily at prices at least 30% under par for high coupon