The “aggressive” investor should start from the same base as the defensive investor, namely, a division of his funds between high-grade bonds and high-grade common stocks bought at reasonable prices.^* He will be prepared to branch out into other kinds of security commitments, but in each case he will want a well-reasoned justification for the departure. There is a difficulty in discussing this topic in orderly fashion, because there is no single or ideal pattern for aggressive operations. The field of choice is wide; the selection should depend not only on the individual’s competence and equipment but perhaps equally well upon his interests and preferences.

The most useful generalizations for the enterprising investor are of a negative sort. Let him leave high-grade preferred stocks to corporate buyers. Let him also avoid inferior types of bonds and preferred stocks unless they can be bought at bargain levels—which means ordinarily at prices at least 30% under par for high-coupon issues, and much less for the lower coupons.^* He will let someone else buy foreign-government bond issues, even though the yield may be attractive. He will also be wary of all kinds of new issues, including convertible bonds and preferreds that seem quite tempting and common stocks with excellent earnings confined to the recent past.

For standard bond investments the aggressive investor would do well to follow the pattern suggested to his defensive confrere, and make his choice between high-grade taxable issues, which can now be selected to yield about 7¼%, and good-quality tax-free bonds, which yield up to 5.30% on longer maturities.^†

Second-Grade Bonds and Preferred Stocks

Since in late-1971 it is possible to find first-rate corporate bonds to yield 7¼%, and even more, it would not make much sense to buy second-grade issues merely for the higher return they offer. In fact corporations with relatively poor credit standing have found it virtually impossible to sell “straight bonds”—i.e., nonconvertibles—to the public in the past two years. Hence their debt financing has been done by the sale of convertible bonds (or bonds with warrants attached), which place them in a separate category. It follows that virtually all the nonconvertible bonds of inferior rating represent older issues which are selling at a large discount. Thus they offer the possibility of a substantial gain in principal value under favorable future conditions—which would mean here a combination of an improved credit rating for the company and lower general interest rates.

But even in the matter of price discounts and resultant chance of principal gain, the second-grade bonds are in competition with better issues. Some of the well-entrenched obligations with “old-style” coupon rates (2½% to 4%) sold at about 50 cents on the dollar in 1970. Examples: American Telephone & Telegraph 2 5/8s, due 1986 sold at 51; Atchison Topeka & Santa Fe RR 4s, due 1995, sold at 51; McGraw-Hill 3 7/8s, due 1992, sold at 50½.

Hence under conditions of late-1971 the enterprising investors can probably get from good-grade bonds selling at a large discount all that he should reasonably desire in the form of both income and chance of appreciation.

Throughout this book we refer to the possibility that any well-defined and protracted market situation of the past may return in the future. Hence we should consider what policy the aggressive investor might have to choose in the bond field if prices and yields of high-grade issues should return to former normals. For this reason we shall reprint here our observations on that point made in the 1965 edition, when high-grade bonds yielded only 4½%.

Something should be said now about investing in second-grade issues, which can readily be found to yield any specified return up to 8% or more. The main difference between first- and second- grade bonds is usually found in the number of times the interest charges have been covered by earnings. Example: In early 1964 Chicago, Milwaukee, St. Paul and Pacific 5% income debenture bonds, at 68, yielded 7.35%. But the total interest charges of the road, before income taxes, were earned only 1.5 times in 1963, against our requirement of 5 times for a well-protected railroad issue.¹

Many investors buy securities of this kind because they “need income” and cannot get along with the meager return offered by top-grade issues. Experience clearly shows that it is unwise to buy a bond or a preferred which lacks adequate safety merely because the yield is attractive.^* (Here the word “merely” implies that the issue is not selling at a large discount and thus does not offer an opportunity for a substantial gain in principal value.) Where such securities are bought at full prices—that is, not many points under 100 ^* —the chances are very great that at some future time the holder will see much lower quotations. For when bad business comes, or just a bad market, issues of this kind prove highly susceptible to severe sinking spells; often interest or dividends are suspended or at least endangered, and frequently there is a pronounced price weakness even though the operating results are not at all bad.

As a specific illustration of this characteristic of second-quality senior issues, let us summarize the price behavior of a group of ten railroad income bonds in 1946–47. These comprise all of those which sold at 96 or more in 1946, their high prices averaging 102½. By the following year the group had registered low prices averaging only 68, a loss of one-third of the market value in a very short time. Peculiarly enough, the railroads of the country were showing much better earnings in 1947 than in 1946; hence the drastic price decline ran counter to the business picture and was a reflection of the selloff in the general market. But it should be pointed out that the shrinkage in these income bonds was proportionately larger than that in the common stocks in the Dow Jones industrial list (about 23%). Obviously the purchaser of these bonds at a cost above 100 could not have expected to participate to any extent in a further rise in the securities market. The only attractive feature was the income yield, averaging about 4.25% (against 2.50% for first-grade bonds, an advantage of 1.75% in annual income). Yet the sequel showed all too soon and too plainly that for the minor advantage in annual income the buyer of these second-grade bonds was risking the loss of a substantial part of his principal.

The above example permits us to pay our respects to the popular fallacy that goes under the sobriquet of a “businessman’s investment.” That involves the purchase of a security showing a larger yield than is obtainable on a high-grade issue and carrying a correspondingly greater risk. It is bad business to accept an acknowledged possibility of a loss of principal in exchange for a mere 1 or 2% of additional yearly income. If you are willing to assume some risk you should be certain that you can realize a really substantial gain in principal value if things go well. Hence a second-grade 5.5 or 6% bond selling at par is almost always a bad purchase. The same issue at 70 might make more sense—and if you are patient you will probably be able to buy it at that level.

Second-grade bonds and preferred stocks possess two contradictory attributes which the intelligent investor must bear clearly in mind. Nearly all suffer severe sinking spells in bad markets. On the other hand, a large proportion recover their position when favorable conditions return, and these ultimately “work out all right.” This is true even of (cumulative) preferred stocks that fail to pay dividends for many years. There were a number of such issues in the early 1940s, as a consequence of the long depression of the 1930s. During the postwar boom period of 1945–1947 many of these large accumulations were paid off either in cash or in new securities, and the principal was often discharged as well. As a result, large profits were made by people who, a few years previously, had bought these issues when they were friendless and sold at low prices.²

It may well be true that, in an overall accounting, the higher yields obtainable on second-grade senior issues will prove to have offset those principal losses that were irrecoverable. In other words, an investor who bought all such issues at their offering prices might conceivably fare as well, in the long run, as one who limited himself to first-quality securities; or even somewhat better.³

But for practical purposes the question is largely irrelevant. Regardless of the outcome, the buyer of second-grade issues at full prices will be worried and discommoded when their price declines precipitately. Furthermore, he cannot buy enough issues to assure an “average” result, nor is he in a position to set aside a portion of his larger income to offset or “amortize” those principal losses which prove to be permanent. Finally, it is mere common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market.

Foreign Government Bonds

All investors with even small experience know that foreign bonds, as a whole, have had a bad investment history since 1914. This was inevitable in the light of two world wars and an intervening world depression of unexampled depth. Yet every few years market conditions are sufficiently favorable to permit the sale of some new foreign issues at a price of about par. This phenomenon tells us a good deal about the working of the average investor’s mind—and not only in the field of bonds.

We have no concrete reason to be concerned about the future history of well-regarded foreign bonds such as those of Australia or Norway. But we do know that, if and when trouble should come, the owner of foreign obligations has no legal or other means of enforcing his claim. Those who bought Republic of Cuba 4½s as high as 117 in 1953 saw them default their interest and then sell as low as 20 cents on the dollar in 1963. The New York Stock Exchange bond list in that year also included Belgian Congo 5¼s at 36, Greek 7s at 30, and various issues of Poland as low as 7. How many readers have any idea of the repeated vicissitudes of the 8% bonds of Czechoslovakia, since they were first offered in this country in 1922 at 96½? They advanced to 112 in 1928, declined to 67 3/4 in 1932, recovered to 106 in 1936, collapsed to 6 in 1939, recovered (unbelievably) to 117 in 1946, fell promptly to 35 in 1948, and sold as low as 8 in 1970!

Years ago an argument of sorts was made for the purchase of foreign bonds here on the grounds that a rich creditor nation such as ours was under moral obligation to lend abroad. Time, which brings so many revenges, now finds us dealing with an intractable balance-of-payments problem of our own, part of which is ascribable to the large-scale purchase of foreign bonds by American investors seeking a small advantage in yield. For many years past we have questioned the inherent attractiveness of such investments from the standpoint of the buyer; perhaps we should add now that the latter would benefit both his country and himself if he declined these opportunities.

New Issues Generally

It might seem ill-advised to attempt any broad statements about new issues as a class, since they cover the widest possible range of quality and attractiveness. Certainly there will be exceptions to any suggested rule. Our one recommendation is that all investors should be wary of new issues—which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased.

There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance.^* The second is that most new issues are sold under “favorable market conditions”—which means favorable for the seller and consequently less favorable for the buyer.^†

The effect of these considerations becomes steadily more important as we go down the scale from the highest-quality bonds through second-grade senior issues to common-stock flotations at the bottom. A tremendous amount of financing, consisting of the repayment of existing bonds at call price and their replacement by new issues with lower coupons, was done in the past. Most of this was in the category of high-grade bonds and preferred stocks. The buyers were largely financial institutions, amply qualified to protect their interests. Hence these offerings were carefully priced to meet the going rate for comparable issues, and high-powered salesmanship had little effect on the outcome. As interest rates fell lower and lower the buyers finally came to pay too high a price for these issues, and many of them later declined appreciably in the market. This is one aspect of the general tendency to sell new securities of all types when conditions are most favorable to the issuer; but in the case of first-quality issues the ill effects to the purchaser are likely to be unpleasant rather than serious.

The situation proves somewhat different when we study the lower-grade bonds and preferred stocks sold during the 1945–46 and 1960–61 periods. Here the effect of the selling effort is more apparent, because most of these issues were probably placed with individual and inexpert investors. It was characteristic of these offerings that they did not make an adequate showing when judged by the performance of the companies over a sufficient number of years. They did look safe enough, for the most part, if it could be assumed that the recent earnings would continue without a serious setback. The investment bankers who brought out these issues presumably accepted this assumption, and their salesmen had little difficulty in persuading themselves and their customers to a like effect. Nevertheless it was an unsound approach to investment, and one likely to prove costly.

Bull-market periods are usually characterized by the transformation of a large number of privately owned businesses into companies with quoted shares. This was the case in 1945–46 and again beginning in 1960. The process then reached extraordinary proportions until brought to a catastrophic close in May 1962. After the usual “swearing-off” period of several years the whole tragicomedy was repeated, step by step, in 1967–1969.^*

New Common-Stock Offerings

The following paragraphs are reproduced unchanged from the 1959 edition, with comment added:

In the 1965 edition we continued our discussion of this subject as follows:

We followed these paragraphs in the 1965 edition by citing “A Horrible Example,” namely, the sale of stock of Aetna Maintenance Co. at $9 in November 1961. In typical fashion the shares promptly advanced to $15; the next year they fell to 2 3/8, and in 1964 to 7/8. The later history of this company was on the extraordinary side, and illustrates some of the strange metamorphoses that have taken place in American business, great and small, in recent years. The curious reader will find the older and newer history of this enterprise in Appendix 5.

It is by no means difficult to provide even more harrowing examples taken from the more recent version of “the same old story,” which covered the years 1967–1970. Nothing could be more pat to our purpose than the case of AAA Enterprises, which happens to be the first company then listed in Standard & Poor’s Stock Guide. The shares were sold to the public at $14 in 1968, promptly advanced to 28, but in early 1971 were quoted at a dismal 25¢. (Even this price represented a gross overvaluation of the enterprise, since it had just entered the bankruptcy court in a hopeless condition.) There is so much to be learned, and such important warnings to be gleaned, from the story of this flotation that we have reserved it for detailed treatment below, in Chapter 17.