Few books have been able to withstand the test of time in better form than The Intelligent Investor. Written by Benjamin Graham in 1949 as a guide to investing principles designed to be accessible to the general public, The Intelligent Investor clearly presents not only information regarding sound selection of securities but, perhaps more importantly, the correct mindset that separates true investors from speculators. For decades, Warren Buffett has recommended that readers pay particular attention to Chapters 8 and 20 covering how investors should think about market fluctuations and margin of safety.
In Chapter 7 of The Intelligent Investor, Benjamin Graham presents three recommended fields for “enterprising investors”:
- The Relatively Unpopular Large Company
- Purchase of Bargain Issues
- Special Situations or Workouts
At the market lows in 2009, it is reasonable to assume that even someone as conservative as Ben Graham would have found ample “bargain issues” available for purchase. However, the very strong bull market over the past year erased many deep bargain opportunities. There are always special situations, but this is not a field that many investors feel comfortable with. Unpopular large companies, however, will always be with us for a variety of reasons. Certainly there is no shortage today of large companies that are disliked or even despised by politicians and the general public.
Why Large Companies?
There are certainly many unpopular companies of all sizes, many of which trade at depressed levels, so why should investors focus on larger companies? The following excerpt from Chapter 7 provides the rationale:
If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.
The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown. (fourth revised edition, 1973: page 79)
Essentially, the argument is that if an investor can identify strong enterprises with a record of meaningful profitability, a temporary setback may provide an opportunity to make a bargain purchase if Mr. Market has misunderstood the situation and assumed that the difficulties are permanent rather than temporary. By looking at larger companies that have the financial strength to withstand a potentially protracted period of adversity, the investor can hedge against the risk that would exist in a smaller enterprise that may face similar headwinds but fail to make it to an eventual upturn.
Unpopular Sectors Today …
There are always several sectors facing economic or political headwinds but two in particular seem to be potential opportunities for investors today:
- Oilfield Services. Due to the disastrous oil spill that is still underway in the Gulf of Mexico, few industries are facing as much near term uncertainty as those involved in the oil and gas industry. The companies that are directly involved include BP, Transocean, Cameron International, and Halliburton all of which are down sharply over the past month. Beyond those companies directly involved, oilfield service and equipment companies have been punished in general. These companies have various degrees of exposure to offshore drilling. Within the offshore oriented firms, there are different exposures to shallow vs. deepwater along with regional differences as well. Despite the tragic situation in the Gulf of Mexico as well as the near certainty of higher regulatory costs going forward, America and the rest of the world will be heavily dependent on oil for at least twenty years and probably much longer.
- Medical Device Industry. The new health care law has broad implications for all businesses involved in the delivery of health care. Medical device companies will soon be facing a 2.3 percent excise tax on gross sales of most medical devices. The largest companies are obviously expected to bear the most significant cost given the fact that this is a gross receipts tax. The other major headwind facing the industry is that consumers of medical devices (ultimately the insurers) are putting increasing pressure on suppliers to hold the line on price increases. On a positive note, a larger potential market will exist for medical devices based on the aging population and a larger number of individuals having health coverage under the new system.
These are just two examples of industries that are not popular with investors today for very different underlying reasons. There are many companies in both industries with long records of high profitability. The difficulty is always separating the companies that may be facing long term decline from those that will recover once near term issues are resolved.
In the coming days, we will present some potential ideas from these industries. The idea is not to necessarily identify companies that qualify for immediate investment, but to examine unpopular situations based on how they might have looked to Benjamin Graham. Some companies may be interesting but are not depressed enough to offer a margin of safety today. It is still a good exercise to examine as many companies as possible so one is able to act promptly if market prices eventually offer a better entry point.
Disclosure: No position in any company mentioned in this article.