Part 6:  Portfolio Policy for the Enterprising Investor: Negative Approach

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💥 Why This Matters

• Demand a Margin of Safety: When venturing beyond the highest-grade securities, an investor must only do so when there’s a clear discount to what that asset is worth.

• Avoid IPOs: Whether it’s the hot IPO or a company refinancing its debt – avoid new offerings. The incentives of the sellers, and the psychology of the buyers, often lead to inflated prices

• Don’t Confuse Yield with Value: This is the “businessman’s investment” fallacy. Chasing a slightly higher yield on a shaky bond or preferred stock is a bad trade if it comes with significant risk of losing your principal

 ⚖️ Aggressive vs Defensive Investors

Whether you identify as a more aggressive (enterprising) investor or a defensive investor — what you don’t do is just as important to your success as what you do.

Here our friend Charlie Munger comes to mind…

Charlie said if you when trying to solve a problem – invert it. Always invert.

This phrase however is inspired by the German mathematician Carl Gustav Jacob Jacobi, who advised solving problems by turning them on their head.

Munger said to tackle challenges, we should look at them backward to gain new perspectives.

For example, instead of asking, “how can I be successful?” ask, “what would make me fail?” and then avoid those things.

Chapter 6 is Graham’s list of inversions for the aggressive investor (i.e., those willing to take on additional risk in pursuit of higher returns)

For example, he emphasizes that this doesn’t mean blindly chasing high-yield or high-risk momentum stocks.

That’s not what to do. Aggressive doesn’t mean reckless.

Instead, he advocates for a calculated approach, understanding the potential downsides and prioritizing the preservation of capital.

With this in mind – let’s review his set of criteria for a growth-oriented investor.

📈 Rules for Aggressive Investors

1. 🦺 Foundation in Safety

Even aggressive (growth seeking / higher return) investors should start with a solid base of higher-grade stocks and bonds. This foundation provides stability and a buffer against losses in riskier ventures. For example, seek quality with respect to attributes such as (not limited to): (i) positive and consistent free cash flow; (ii) strong balance sheets; (iii) consistent operating and profit margins; (iv) revenue and earnings growth; and (v) proven defensive moats

2. 📃 Well-Reasoned Justification

Every investment should be thoroughly researched and justified. For example, how well do you understand what products and services they bring to market? What share of the market do they have? What are they doing that their competitors cannot? What’s their sales-to-price ratio? Price-to-cash-flow ratio? Forward earnings ratio? Price-to-book ratio etc etc. Avoid impulsive decisions based solely on potential returns.

3. ❎ Negative Generalizations

Graham offers several “don’ts” for the aggressive investor:

• Avoid high-grade preferred stocks: Their relatively low yields make them more suitable for corporate investors seeking tax advantages.
• Steer clear of inferior bonds and preferred stocks: Unless they are significantly discounted (at least 30% below par for high-coupon issues), the risks outweigh the potential rewards.
• Skip foreign government bonds: Despite potentially attractive ‘double digit’ yields, they carry significant risks due to a lack of investor protection in case of default.
• Be wary of new issues: New offerings, including IPOs and convertible securities, are often overpriced and subject to hype, making them riskier for investors

4. 🪨 Bond Strategies

• Prioritize high-grade taxable or tax-free bonds: In a normal market environment, these offer a reasonable balance of income and safety.
• Consider discounted high-grade bonds: When available, these can provide a combination of income and potential for appreciation if interest rates decline
• Avoid second-grade bonds at full price: The higher yields of lower-quality bonds often don’t compensate for the increased risk of default or price declines during market downturns.
• Opportunistically buy second-grade bonds at deep discounts: If available at significantly depressed prices (e.g., 70% of face value), these bonds might offer a substantial upside potential along with higher yields.

5. 💼 Resist the “Businessman’s Investment” Fallacy

Don’t fall for the trap of accepting higher risk for marginally higher yields. This is commonly referred to as “picking up pennies in front of a steam roller“. If taking on risk, ensure there’s a potential for significant principal appreciation if the investment succeeds.

6. 🥈 Understand the Nature of Second-Grade Bonds

7. 🌎 Avoid Foreign Government Bonds

Historically, foreign bonds have been risky due to geopolitical events and the lack of recourse for investors in case of default (for e.g., Russia defaulting on its debt in the 1990s)

8. 📰 Exercise Caution with New Issues and IPOs

• High-grade bonds and preferred stocks: While institutional investors generally price these fairly, individual investors might overpay due to aggressive sales tactics
• Lower-grade bonds and preferred stocks: These are often riskier and marketed to less experienced investors who may not fully understand the risks
• IPOs: The initial public offering process often leads to inflated prices, and many (or most) new companies fail to live up to expectations.

9. 💰 Never Chase “Easy Money”

Resist the temptation to get caught up in a speculative frenzy. While some may offer quick profits, the long-term odds are often stacked against the investor.

 4 Key Takeaways

Aggressive investing doesn’t need to be reckless. Investors who accept the risks opposite higher returns should focus on 4 key qualities:

• Discipline: Adhering to a well-thought-out investment strategy and avoiding impulsive decisions
• Patient: Waiting for opportunities to buy undervalued securities and resisting the urge to chase market trends
• Skeptical: Critically evaluating investment opportunities, particularly new issues and those promising high returns with minimal risk..
• Value-Oriented: Focusing on the intrinsic value of securities rather than market hype or short-term price fluctuations

By following these principles, the aggressive investor can increase their margin of safety (i.e., mitigate risk) whilst targeting growth.