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By Root 2596 0

from that before the war. Whereas the leading stocks in the Dow Jones Industrial Average had advanced only 40% from the end of 1938 to the 1946 high, Standard & Poor’s index of low-priced stocks had shot up no less than 280% in the same period. Speculators and many self-styled investors—with the proverbial short memories of people in the stock market—were eager to buy both old and new issues of unimportant companies at inflated levels. Thus the pendulum had swung clear to the opposite extreme. The very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of overenthusiasm and overvaluation. In a different way this phenomenon was repeated in 1961 and 1968—the emphasis now being placed on new offerings of the shares of small companies of less than secondary character, and on nearly all companies in certain favored fields such as “electronics,” “computers,” “franchise” concerns, and others.*

As was to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum swing may have gone as far as definite under valuation.

If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways. First, the dividend return is relatively high. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price. In a five-to seven-year period these advantages can bulk quite large in a well-selected list. Third, a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. Fifth, the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions, or the adoption of new policies, or by a change in management.

An important new factor in recent years has been the acquisition of smaller companies by larger ones, usually as part of a diversification program. In these cases the consideration paid has almost always been relatively generous, and much in excess of the bargain levels existing not long before.

When interest rates were much lower than in 1970, the field of bargain issues extended to bonds and preferred stocks that sold at large discounts from the amount of their claim. Currently we have a different situation in which even well-secured issues sell at large discounts if carrying coupon rates of, say, 4½% or less. Example: American Telephone & Telegraph 2 5/8s, due 1986, sold as low as 51 in 1970; Deere & Co. 4½s, due 1983, sold as low as 62. These may well turn out to have been bargain opportunities before very long—if ruling interest rates should decline substantially. For a bargain bond issue in the more traditional sense perhaps we shall have to turn once more to the first-mortgage bonds of railroads now in financial difficulties, which sell in the 20s or 30s. Such situations are not for the inexpert investor; lacking a real sense of values in this area, he may burn his fingers. But there is an underlying tendency for market decline in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis. In the decade ending in 1948 the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area. Such opportunities have been quite scarce since then; but they seem likely to return in the 1970s.*

Special Situations, or “Workouts