Part 7:  Portfolio Policy for the Enterprising Investor: Positive Approach

Words: 2,354  Time: 10 Minutes

💥 Why This Matters

• Stock Investment Strategies: Cautiously selecting growth stocks, purchasing bargain issues, and focusing on special situations. Each strategy leverages specific market cycles, valuations, or unique situations, requiring careful analysis but potentially yielding substantial returns

• Bond Market Opportunities: There are bond options which present higher rewards for investors willing to navigate moderate risks, as compared to traditional, low-risk bonds.

• Consistent Return Focus: To maintain above-average returns, Graham advises investing in unpopular large companies, bargain issues, and stocks during market downturns. These areas typically offer undervalued opportunities that are likely to correct as market sentiment improves, allowing more aggressive investors to benefit from strategic timing and valuation insights

📐 Strategic Framework 

The previous chapter outlined strategies to avoid for aggressive (growth oriented) investors.

This chapter shifts focus to proactive approaches.

Graham provides a comprehensive framework for those willing to dedicate significant effort and skill to outperform the benchmark returns (i.e., ‘alpha’)

Unlike defensive investors, who prioritize stability, enterprising investors actively seek high-potential returns by identifying market inefficiencies. This involves meticulous research and a focus on undervalued assets in bonds, stocks, and special situations.

I personally identify with this approach, leveraging time to diligently study companies and market trends.

This has yielded a consistent 15% annualized return over the past decade (see here). However, I emphasize that this requires a disciplined commitment and substantial time investment

📜 Fixed Income: A Cornerstone of a Balanced Portfolio

Graham emphasized the importance of fixed income investments as a crucial component of a balanced portfolio.

Graham student – Warren Buffett – maintains a significant portion of his portfolios in short-term bonds, underscoring the enduring appeal of this asset class.

To start, let’s explain why investing in fixed income offers investors 3 key advantages:

1. Stability: Bonds provide a relatively stable income stream, making them ideal for more risk-averse investors.

2. Diversification: Incorporating bonds into a portfolio can help reduce overall risk by offsetting fluctuations in stocks; and

3. Tax Benefits: Certain types of bonds, such as municipal bonds, offer tax advantages, potentially boosting after-tax returns.

Exploring Fixed Income Options

Graham explored various fixed-income options that could provide both security and potentially attractive returns.

One such option he highlighted was tax-exempt municipal bonds.

These bonds, issued by states, municipalities, and other government entities, offer interest income that is exempt from federal income tax and, in many cases, state and local taxes.

By investing in municipal bonds, you can effectively shield your investment income from taxes, allowing your portfolio to grow more rapidly.

This strategy is particularly beneficial for high-income individuals who are subject to higher tax rates.

By way of example, as part of this post, I offered readers 4 options for tax-free bond investing:

Practical Tips for Fixed Income Investing:

1. Diversify: Spread your investments across various issuers and maturities to reduce risk.

3. Monitor Interest Rates: Stay informed about interest rate trends, as they can impact the value of your bond holdings (see this post for a practical example)

For investors seeking higher returns, Graham also discussed the potential of lower-quality bonds, often referred to as high-yield or junk bonds.

These bonds, while riskier than investment-grade bonds, can offer significantly higher yields. However, it’s crucial to carefully assess the creditworthiness of the issuer and diversify your holdings to mitigate risk.

Howard Marks, for example, is well-known for his expertise in investing in distressed debt and other high-yield fixed income securities. His approach involves rigorous analysis and a deep understanding of credit cycles.

By carefully considering your risk tolerance and investment objectives, you can construct a fixed income portfolio that aligns with your financial goals.

Whether you prefer the stability of traditional bonds or the higher potential returns of riskier investments, fixed income can be a valuable tool in your overall investment (and tax) strategy.

🥷 Stock Investment Strategies

If investing was as simple as “buying low and selling high” – this game would be easy.

The investing panacea is to buy assets when they are cheap and sell them when they become overpriced. And as we wait for prices to become cheap again – we simply hide in the bunker of bonds and cash.

Right?

However, there’s a lot more to the maxim of simply “buying low and selling high”.

To start, most people simply replace “low” with “popular”.

In one of my favorite quotes – Warren Buffet described it this way:

“… in the short term, the stock market is a voting machine, but in the long term, it’s a weighing machine“

It’s worth us spending moment on Buffett’s timeliness quote – as it’s core to the essence of Graham’s thesis (and Buffett’s own philosophy)

In the short term, stock prices are influenced by the collective opinions, emotions, and behaviors of market participants. These can include factors like (not limited to):

• Popularity or hype around a stock or sector.
• Market trends, media coverage, and social sentiment.
• Fear, greed, and speculation.
• Short-term earnings reports, news events, or economic data.

‘Voting’ reflects the aggregated preferences and actions of investors, which can often lead to mispricing. Stocks may be overvalued or undervalued based on crowd psychology rather than their intrinsic worth (i.e., their value)

However, over time, the market tends to reflect the true intrinsic value of a company, determined by its fundamentals, such as:

• Revenue and earnings growth
• Profit margins and cash flow
• Competitive position and management quality
• Economic and industry trends.

Buffett’s analogy suggests that over the long term, the stock market will “weigh” these fundamentals accurately, aligning stock prices with a company’s real value.

Companies with strong fundamentals will (ultimately) see their stock prices rise accordingly, while those with weak fundamentals will see declines.

What follows is a list of strategies from Graham which help investors increase the probability of stronger (more consistent) returns.

These strategies include buying in under-valued markets; selecting growth stocks with diligence; investing in bargain issues, and focusing on special situations (for more skilled investors).

1. The Price You Pay Determines Your Return

Regular readers of my blog will often hear me say “it’s not simply what we buy – it’s how much we pay that counts”.

How much you pay will ultimately determine your return.

Executing on this strategy requires capitalizing on market fluctuations by buying undervalued stocks during economic downturns and selling them when the market is overly optimistic.

However, while this approach offers substantial potential returns, accurately timing the market demands sophisticated insights and certain ‘predictive abilities’ that may be difficult for the average investor to master.

For example not only is a deep understanding of company fundamentals required (something we will explore with worked examples in subsequent chapters) – but so too is an understanding of market cycles.

Entering or exiting the market at the wrong time can significantly impact returns (see Part 3 of this series).

2. Selecting Growth Stocks with Caution

Although growth stocks are often perceived as ideal investments, they are typically priced at a premium due to optimistic market expectations.

This premium can cap potential gains, as anticipated growth may not always match reality.

Therefore, growth based investors should carefully evaluate growth stocks to avoid overpaying, as even accurate growth predictions may yield only moderate returns if stocks are overvalued from the outset.

Additionally, the rapid growth of a company may eventually plateau, especially as its size and market share grow, limiting further stock price appreciation.

At the time of writing (October 2024) – this is particularly relevant for investors.

For example, as someone who has worked in field of GenerativeAI for ~10 years with Google, I’ve recently reduced my exposure to certain large cap tech stocks due to high valuations.

Apple is a good example.

As at November 2024 – it currently trades 32x forward earnings growth the top line by single digits. And whilst I think it’s a very high quality company – you can still overpay.

Let’s use the chart below as a timestamp for Apple – and revisit it in 5 years and whether it’s outperformed the benchmark index. 

Nov 23 2024

3. Purchasing Bargain Issues

Identifying securities trading below their intrinsic value is a core strategy for enterprising investors.

This strategy is the pillar of Warren Buffett’s success.

Let’s come back to Apple….

For example, if we refer to the chart above, Buffett invested in Apple in 2016 when the stock traded at a forward PE of less than 12x for a price of around $23 (split adjusted)

In Q3 2024 – he sold 56% of his position at a price of ~$230 for an 8-year average CAGR of 33.3%

With Apple, in 2016, Buffett identified a stock trading well below its intrinsic worth. At the time, it was out of favor.

However, when Apple became extremely popular – trading at 32x forward earnings – Buffett was willing to part with two-thirds of his holding.

4. Focusing on Special Situations

Special situations, such as acquisitions, restructurings, or legal developments, can create short-term fluctuations in stock prices, presenting unique investment opportunities.

For those knowledgeable about these scenarios, returns can be substantial due to the market anomalies involved.

Unlike traditional investments that rely on organic growth, special situations are driven by unique events that temporarily impact stock prices, allowing enterprising investors to capitalize on short-term mispricing.

📐 A Model for More Consistent Returns

To achieve above-average returns consistently, Chapter 7 suggests that more aggressive investors should focus on three specific areas: 

• Unpopular large companies (Buffett acquiring Apple in 2016 an example);
• Bargain issues; and
• Buying during market downturns.

1. Unpopular Large Companies

• Large companies that are temporarily out of favor with the market often recover reliably due to their robust fundamentals.
• By investing in these stocks during periods of low market sentiment, enterprising investors can benefit from the cyclical nature of the market.
• As these stocks regain market favor, their value typically increases, offering conservative yet promising returns.
• This strategy allows investors to leverage temporary setbacks without assuming excessive risk, as large companies are more likely to recover due to their established market presence

2. Purchasing Bargain Issues

• This approach involves acquiring undervalued stocks trading well below their intrinsic value, usually due to short-term market pessimism or company-specific challenges.
• Graham emphasizes a benchmark, stating that an ideal bargain should have an intrinsic value at least 50% higher than its current market price (which can be attained by assessing its book value)
• Aggressive investors can profit as the market eventually corrects the stock’s undervaluation, allowing its price to approach or exceed intrinsic value.
• By choosing fundamentally stable companies experiencing temporary setbacks, enterprising investors can avoid excessive risk while reaping substantial returns when market conditions improve

3. Buying in Depressed Markets

• Market downturns present an opportunity to buy stocks at significantly undervalued prices, as many stocks drop below their intrinsic values during these periods.
• Historical data shows that stocks often rebound from low points, providing rewards to those who purchase during times of market pessimism.
• However, it is critical to distinguish between companies experiencing temporary declines and those with long-term issues, as not all stocks will recover.
• Aggressive investors who buy quality stocks in depressed markets stand to benefit from the eventual market upturns.

🧠 Criteria for Value & Investor Mindsets

Graham underlines the distinct mindsets of defensive and more aggressive investors and the criteria they must consider. 

• Defensive investors, who prefer low-risk, stable returns, are advised to invest in large, financially sound companies with strong fundamentals.

• Aggressive investors, willing to assume more risk, should target undervalued or secondary stocks but must perform careful analysis to avoid potential losses. 

“Secondary stocks” may lack the prominence of industry leaders, often trade at a discount due to market neglect or perceived risk.

However, history shows that many of these companies remain profitable and stable, offering significant profit potential when undervalued relative to earnings or assets.

⚖️ Advantages and Risks of Bargain Stocks

Purchasing stocks below intrinsic value can be profitable when certain criteria are met.

For example, stocks selling at prices less than their net working capital provide a margin of safety, as investors pay nothing for fixed assets or goodwill.

Although secondary stocks may remain undervalued for long periods, they can generate high returns through dividend growth and reinvested earnings, particularly in bullish markets.

Additionally, undervalued stocks often correct over time due to favorable conditions like mergers, management changes, or improved market sentiment.

❄️ Special Situations 

Special situations, including acquisitions and corporate reorganizations, offer additional investment opportunities for enterprising investors.

Acquisitions, particularly those focused on diversification, often result in buyouts at premiums, rewarding investors who bought shares at undervalued prices.

Similarly, legal proceedings and bankruptcies can create short-term price dips due to market aversion, opening opportunities for those able to assess the risk accurately.

However, this area requires expertise and is generally unsuitable for less experienced investors.

One investor who is particularly skilled at this is Seth Klarman.

Klarman details his approach in his book “Margin of Safety -Risk-Averse Value Investing Strategies for the Thoughtful Investor“

He’s often compared to Warren Buffett due to the value investing principles that he applies. This approach has seen Klarman realize an average annual return of 20% over the last 30 years – a very rare accomplishment.

You can track Klarman’s portfolio here.

 3 Key Takeaways

• A disciplined, research-based approach is recommended for aggressive investors who seek to maximize returns by exploiting market inefficiencies.

• By focusing on undervalued stocks with reliable fundamentals, enterprising investors can achieve sustainable growth

• Avoiding speculative investments and adopting a contrarian perspective enables them to capitalize on mispricings in the market, ensuring meaningful and sustainable returns through a commitment to long-term value and strategic decision-making