The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [72]
By something of a coincidence, each of the groups advanced in the two years to somewhere in the neighborhood of the aggregate net-current-asset value. The gain for the entire “portfolio” in that period was 75%, against 50% for Standard & Poor’s 425 industrials. What is more remarkable is that none of the issues showed significant losses, seven held about even, and 78 showed appreciable gains.
Our experience with this type of investment selection—on a diversified basis—was uniformly good for many years prior to 1957. It can probably be affirmed without hesitation that it constitutes a safe and profitable method of determining and taking advantage of undervalued situations. However, during the general market advance after 1957 the number of such opportunities became extremely limited, and many of those available were showing small operating profits or even losses. The market decline of 1969–70 produced a new crop of these “sub-working-capital” stocks. We discuss this group in Chapter 15, on stock selection for the enterprising investor.
TABLE 7-4 Profit Experience of Undervalued Stocks, 1957–1959
BARGAIN-ISSUE PATTERN IN SECONDARY COMPANIES. We have defined a secondary company as one that is not a leader in a fairly important industry. Thus it is usually one of the smaller concerns in its field, but it may equally well be the chief unit in 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 a 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 rejected 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 heading 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