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The Enterprising Investor Portfolio Policy – Ch 7 of The Intelligent Investor

Benjamin Graham defines the enterprising investor as someone who will “devote a fair amount of his attention and efforts toward obtaining a better than run-of-the-mill investment result”.

Now, what are some ways that someone could be an enterprising investor?

Graham identifies 3 types of government bonds that an investor could buy, and 4 different ways that someone could approach buying common stocks. He defines those as:

1. Buying into low markets and selling into high markets

2. Buying carefully chosen “growth stocks”

3. Buying bargain issues of various types

4. Buying into “special situations”

Benjamin Graham; The Intelligent Investor

Let’s take a look at what Graham says about each strategy in the book:

Stock Approach #1 – Market Timing

Graham reiterates that while some people might think they are smart enough to time the market (essentially common stock approach #1), he doesn’t recommend doing it as there’s no real mathematical proof that it could work long term.

enterprising investor the intelligent investor summary

He does allow for the enterprising investor to adjust his stocks and bonds allocation depending on how he feels about the attractiveness of the market, as long as the stocks/bonds mix is somewhere between 25-75.

Stock Approach #2 – Growth Stock Investing

A growth stock is defined (usually) as a stock that has grown earnings and/or revenues better than the market for a period of time. So it should make sense for the enterprising investor to buy a group of the best of these for great profits, right?

Graham identifies two chief problems with buying growth stocks, which so perfectly and succinctly describe why many growth investors have done poorly over the years:

  1. A growth stock by definition gets expensive (high valuations), and it’s hard for stocks to maintain high valuations
  2. A business that has grown is now bigger, and it’s harder to grow when you’re bigger than when you were smaller

Graham probably described it better than I did, but those are his two main points boiled down as succinctly as I could.

There’s also the study quoted in the book called Investment Companies published by Arthur Wiesenberger & Company, in which during the decade of the 60s a group of growth stock funds beat the market by about 3% (total, not per year).

Graham cites this as a reason why the average investor shouldn’t even try to do growth investing, as “how can they do better than these professionals who do it full-time?”– which I think is actually a weak argument. I’ve written about the problems with full-time professionals who engage in active management, and how the average investor can do well simply because they aren’t limited with the same restrictions.

But what about the ones who have ridden a growth stock to a 100x gain?

Graham acknowledges that a few people have gotten extraordinarily rich by riding 1 growth stock since the beginning. But he writes that such a feat is extremely hard to do unless you have a close personal relationship with the company, as the temptation to sell will always be there and you’ll likely sell too early as you get too concentrated in one stock.

Takeaway: Graham leaves the enterprising investor with a rule, to not buy stocks where the P/E is higher than around 20. This is similar to the rule he made for the defensive investor, which was to buy stocks trading at a 25 times (or less) multiple of the average of 7 years of earnings.

Stock Approach #3 – Unpopular Stocks; Bargain Issues

It is in this section that Graham introduces a few of the ways to take a value investing approach to try and beat the market.

He mentions two requirements:

  • The strategy must be rational.
  • It must be different than the average investor’s strategy.

Then, the chapter outlines 3 separate ideas for meeting those requirements and achieving superior gains.

1. The Relatively Unpopular Large Company: There are a couple of simple reasons why buying these stocks can lead to outperformance. For one, because they are big, they have the resources (capital, employees, R&D, etc) to improve. And two– because they are big, Wall Street will jump on the stock once the improvements are there.

These both make sense. I’ll also add that mean reversion tends to make profits and stock valuations return to their averages over time, and so a large company with temporary poor earnings can see their profits mean revert for a variety of reasons.

Graham adds some backtest data to the chapter to hammer down his point, which I think should be more closely looked at to make sure there’s no biases that skew the result.

What I find most convincing about this enterprising investor strategy is that it makes sense, it’s simple, and likely… effective.

Note that Graham includes a tip to look at earnings as an average of several years rather than just one when calculating multiples. This is a theme throughout The Intelligent Investor.

2. Purchase of Bargain Issues: Graham defines a bargain issue as an investment (stock, bond, or preferred) with a 50% margin of safety or more. He talks about the method of determining the true intrinsic value of the issue as involving the estimation of future earnings, with the option to determine intrinsic value as if you were taking the business private and looking at the value of the assets and working capital.

I love this quote by Ben Graham that encapsulates why bargain issues may exist in the first place:

The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.

Benjamin Graham; The Intelligent Investor

He expounds on this to summarize that low valuations are (generally) from:

  • Short term earnings disappointment
  • Prolonged periods of negative sentiment

Speaking of disappointment, I was a bit disappointed that Graham didn’t dig into these any deeper, other than give a couple of anecdotal examples. I would’ve liked to see more data about how long periods of un-popularity in the market had led to outperformance in subsequent years.

But, what I love, is the idea on how the enterprising investor can buy these bargain issues with short term disappointment. Graham makes clear that an investor should see that a company has a good track record of earnings in the longer term past, and/or a strong balance sheet to sustain a recovery.

Again this sounds simple but can be so counter-culture to what you hear on Wall Street.

Net-net issues: There’s a third possible group of bargain issues that can lead to outsized gains, and that’s with stocks that are trading at less than their net working capital. This is commonly referred to online as “net net investing” and is hard to do these days with so many people (and capital) on Wall Street.

Ben Graham loves Small Cap Stocks?

As the last source of potential bargain issues, Graham mentions what he calls “secondary companies”, which are defined as businesses that aren’t industry leaders.

The history behind these types of stocks is fascinating, as during the Great Depression most of them got wiped out.

great depression investing

This led to secondary companies being undervalued for years, and then overvalued after World War II, and overvalued again during the many technology IPOs of the 1960s, to being undervalued for years again as the overvalued stocks were hit the hardest in the next market decline.

The way this chapter explains secondary companies makes me believe that most of them can be also defined as “small cap”, as the reasons for their great opportunity can be described similarly. Graham identifies 5 such reasons:

  • Relatively higher dividend yields
  • Reinvested earnings compound more when a stock is undervalued
  • Bull market seems to favor smaller stocks
  • Price adjustment to normal level would raise an undervalued stock
  • New moves by a company can turnaround disappointing performance

It’s a bit of a chicken and the egg thing– are these stocks small because they are undervalued or are they undervalued because the businesses are small. In some cases the answer is obvious, but in others it might not be.

Regardless, these are some nice potential catalysts for the enterprising investor looking to beat the market.

3. Special Situations, or “Workouts”: This can really be summed up by the word arbitrage. It seemed like many of the opportunities described in the book (mainly around M&A and bankruptcies) are no longer applicable.

This is reminiscent of the same take that value investing billionaire Seth Klarman took in his book Margin of Safety, where there’s doubt on if the arbitrage opportunities exist anymore.

What I’m noticing is that arbitrage probably always exists, but it just takes on different forms.

The bottom line is that Graham says that arbitrage can be a fantastic opportunity for enterprising investors, but he doesn’t teach on how one could do it specifically.

Concluding Chapter 7 of The Intelligent Investor

The last words of the chapter sum up some of the most important parts of this book and how the average investor should apply it.

Graham says that the reader needs to think hard on whether he’d like to be a defensive investor (summarized here), or an enterprising investor– based on if you think you have the time and desire to make the effort needed or not.

He admits that most investors probably should be defensive (basically, passive) investors.

As Graham expounds on the difficulties between picking if a stock is a “primary” or “secondary” categorization, he states that this choice on any one stock is a small problem. The biggest, and most impactful, is what kind of investor you choose to be.

And to answer that requires honesty and a heat check on your passion.

If you are really up for the task, then by all means– the rewards for outperformance can be seriously bountiful. But if not, take the safe road and buy an index, for the sake of your sanity and finances.