What the enterprising investor avoids
Graham's "don'ts": second-grade bonds and preferreds, foreign government bonds, and new issues sold on enthusiasm.
FinanceGraham ch. 6About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- List the kinds of security Graham told enterprising investors to avoid, and why
- Explain why new issues usually favour the seller
- Calculate how far a bond sells below its face value
The Intelligent Investor: Benjamin Graham's ideas: lesson 6 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
Try first
You haven't learned this yet, so guess. Guessing before you read helps the explanation stick. Nothing here is scored.
Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 6, "Portfolio Policy for the Enterprising Investor: Negative Approach"
What it is
Graham says the most useful advice for the enterprising investor is negative: what not to buy. His list:
- High-grade preferred stocks: leave them to companies, which (in the U.S. of his day) got a tax advantage from owning them.
- Second-grade bonds and preferred stocks: avoid them unless they are true bargains, which for high-interest issues means at least 30% below par (face value).
- Foreign government bonds: if a foreign government stops paying, a foreign lender has no legal way to make it pay. Graham's example: bonds of the Republic of Cuba sold as high as 117 in 1953, then defaulted and traded at about 20 by 1963.
- New issues: be wary of all of them; the danger grows as you move down from high-grade bonds to new common-stock issues.
Quick check
Tap an answer to check it.
Why does Graham warn against foreign government bonds?
- He sees no concrete reason to worry about well-regarded foreign bonds; the problem is having no remedy if trouble comes
Show answer
If the government stops paying, the bondholder has no legal means of enforcing the claim. No way to enforce payment.
Why it matters
Graham gives two reasons to be wary of new issues:
- They come with special salesmanship behind them, so the buyer needs special sales resistance.
- Most are sold under favourable market conditions, which means favourable for the seller and so less favourable for the buyer.
Zweig, writing after the 1990s boom, adds that the public "has gotten burned on IPOs" again and again, stayed away for at least two years, then always come back. His darker readings of the letters IPO include "It's Probably Overpriced".
Worked example
A bargain bond, by Graham's measure. A bond has a face value (par) of 1,000.
- Bought at 650: it sells 350 below par, or 35% below, past Graham's 30% line for a high-interest issue.
- Bought at 800: only 20% below par: by his measure, not a bargain.
An IPO, in Zweig's example. One technology company was offered to the public at 30 a share in December 1999; on its first day of trading the shares peaked at 320 and closed at about 239. Three years later to the day, they closed at 1.19: a fall of more than 99% from that first close.
Common mistake
Buying a bond or preferred stock only for its high yield. Zweig puts it bluntly: when the yield dries up, there's nothing else there. A higher yield usually means a higher risk that the payments stop.
Key terms
- par
- a bond's face value, the amount repaid at maturity
- preferred stock
- shares that pay a fixed dividend before ordinary shareholders get anything
- second-grade (junk) bond
- a bond from a borrower with weaker credit, paying more interest
- new issue / IPO
- shares or bonds sold to the public for the first time (IPO: initial public offering)
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| par | a bond's face value, the amount repaid at maturity |
| preferred stock | shares that pay a fixed dividend before ordinary shareholders get anything |
| second-grade (junk) bond | a bond from a borrower with weaker credit, paying more interest |
| new issue / IPO | shares or bonds sold to the public for the first time (IPO: initial public offering) |
Practice
Work it through
A preferred stock with a par value of 100 is offered at 62.
- 100 − 62
- 38 ÷ 100 × 100
Sort it
In Graham's view, should the enterprising investor avoid it, or consider it?
A newly listed company's shares in a booming market
Sold when conditions favour the seller.Show answer
Avoid. Sold when conditions favour the seller.
A second-grade, high-coupon bond 40% below par
Past Graham's 30% line for high-coupon issues.Show answer
Consider only at a bargain price. Past Graham's 30% line for high-coupon issues.
A second-grade bond at par, chosen for its yield
Not a bargain; yield alone isn't a reason.Show answer
Avoid. Not a bargain; yield alone isn't a reason.
High-grade preferred stock for an individual
Graham leaves these to companies.Show answer
Avoid. Graham leaves these to companies.
Quick quiz
Tap an answer to check it.
Why are most new issues sold "under favourable market conditions" bad news for buyers?
- Many succeed; the problem is the price paid
Show answer
Conditions favourable to the seller mean a high price for the buyer. Sellers choose the moment that suits them.
In short
- Graham's enterprising "don'ts": high-grade preferreds (leave to companies), second-grade bonds and preferreds unless at bargain prices (for high-coupon issues, 30%+ below par), foreign government bonds, new issues.
- New issues come with salesmanship and are sold when conditions favour sellers.
- Zweig: IPO booms repeat, and buyers usually pay too much.
- Don't buy anything only for its yield.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What discount did Graham ask for before an enterprising investor buys a second-grade, high-interest bond?
Show answer
At least 30% below par.
Give Graham's two reasons to be wary of new issues.
Show answer
Special salesmanship behind them, and they're sold in conditions that favour the seller.
What happened to the Cuban bonds in Graham's example?
Show answer
They sold as high as 117 in 1953, defaulted, and traded at about 20 by 1963.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 6.
- On this site: Bonds and money-market funds.
Finished? Mark it done to fill in your leaf on the Finance map.