WS: INTELLIGENT INVESTOR VII

INTELLIGENT INVESTOR VII

Bargains in Secondary Stocks

We have defined a secondary company as one that is not a leader in a farily important industry. Thus it is usually one of the smaller concerns in its field, but it may equally well be the chief unit of an unimportant line. By way of exception, any company that has established itself as a growth stock is not ordinarily considered "secondary."

In the great bull market of the 1920s relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size. The public felt that a middle-sized company was strong enough to weather storms and that it had a better chance for really spectacular expansion than one that was already of major dimensions. The depression years 1931-32, however, had particularly devastating impact on the companies below the first rank either in size or in inherent stability. As a result of that experience investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance. This has meant that the latter group have usually sold at much lower prices in relation to earnings and assets than have the former. It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.

When investors reject the stocks of secondary companies, even though these sold at relatively low prices, they were expressing a belief or fear that such companies faced a dismal future. In fact, at least subconsciously, they calculated that any price was too high for them because they were headed for extinction-- just as in 1929 the companion theory for the "blue chips" was that no price was too high for them because their future possibilities were limitless. Both of these views were exaggerations and were productive of serious investment errors. Actually, the typical middle-sized listed company is a large one when compared with the average privately owned business. There is no sound reason why such companies should not continue indefinitely in operation, undergoing the vicissitudes characteristic of our economy but earning on the whole a fair return on their invested capital.

This brief review indicates that the stock market's attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation. As it happens, the World War II period and the postwar boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly. Thus by 1946 the market's pattern had completely reversed itself from that before the war. Whereas the leading stocks in the Dow Jones Industrial Average had advanced only 40% from the end of 1938 to the 1946 high, Standard & Poor's index of low-priced stocks had shot up no less than 280% in the same period. Speculators and many self-styled investors-- with the proverbial short memories of people in the stock market-- were eager to buy both old and new issues of unimportant companies at inflated levels. Thus the pendulum had swung clear to the opposite extreme. The very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of overenthusiasm and overvaluation. In a different way this phenomenon was repeated in 1961 and 1968-- the emphasis now being placed on new offerings of the shares of small companies in certain favored fields such as "electronics," "computers," "franchise" concerns, and others.

As was to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum swing may have gone as far as definite undervaluation.

If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the purchase of sescondary companies at bargain prices arise in a variety of ways. First, the dividend return is relatively high. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price. In a five- to seven-year period these advantages can bulk quite large in a well-selected list. Third, a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. Fifth, the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions, or the adoption of new policies, or by a change in management.

An important new factor in recent years has been the acquisition of smaller companies by larger ones, usually as part of a diversification program. In these cases the consideration paid has almost always been relatively generous, and much in excess of the bargain levels existing not long before.

Special Situations, or "Workouts"

No so long ago this was a field which could almost guarantee an attractive rate of return to those who knew their way around in it; and this was true under almost any sort of general market situation. It was not actually forbidden territory to members of the general public. Some who had a flair for this sort of thing could learn the ropes and become pretty capable practitioners without the necessity of long academic study or apprenticeship. Others have been keen enough to recognize the underlying soundness of this approach and to attach themselves to bright young men who handled funds devoted chiefly to these "special situations." But in recent years, for reasons we shall develop later, the field of "arbitrages and workouts" became riskier and less profitable. It may be that in years to come conditions in this field will become more propitious. In any case it is worthwhile outlining the general nature and origin of these operations, with one or two illustrative examples.

The typical "special situation" has grown out of the increasing number of acquisitions of smaller firms by larger ones, as the gospel of diversification of products hads been adopted by more and more managements. It often appears good business for such an enterprise to acquire an existing company in the field it wishes to enter rather than to start a new venture from scratch. In order to make such acquisition possible, and to obtain acceptance of the deal by the required large majority of shareholders of the smaller company, it is almost always necessary to offer a price considerably above the current level. Such corporate moves have been producing interesting profit-making opportuntiies for those who have made a study of this field, and have good judgment fortified by ample experience.

A great deal of money was made by shrewd investors not so many years ago through the purchase of bonds of railroads in bandruptcy-- bonds which they knew would be worth much more than their cost when the railroads were finally reorganized. After promulgation of the plans of reorganization a "when issued" market for the new security appeared. These could almost always be sold for considerably more than the cost of the old issues which were to be exchanged therefor. There were risks of nonconsummation of the plans or of unexpected delays, but on the whole such "arbitrage operations" proved highly profitable.

There were similar opportunities growing out of the breakup of public-utility holding companies pursuant to 1935 legislation. Nearly all these enterprises proved to be worth considerably more when changed from holding companies to a group of separate operating companies.

The underlying factor here is the tendency of the security markets to undervalue issues that are involved in any sort of complicated legal proceedings. An old Wall Street motto has been: "Never buy a lawsuit." This may be sound advice to the speculator seeking quick action on his holdings. But the adoption of this attitude by the general public is bound to create bargain opportunities in the securities affected by it, since the prejudice against them holds their prices down to unduly low levels.

The exploitation of special situations is a technical branch of investment which requires a somewhat unusual mentality and equipment. Probably only a small percentage of our enterpriseing investors are likely to engage in it.


Credits: This article is primarily extracted from Ben Graham's 1973 edition of The Intelligent Investor, Chapter 7.

POSTED :16 Jun 2006