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Chapter 6: The Selection of Fixed Value Investments

Graham addresses the question of whether investment in bonds in logical given the extreme losses suffered during the great depression. He suggests that the 1927-33 experience was so abnormal that it does not constitute a fair basis for judgment.

Fundamental principle of bond investment: Bond form is inherently unattractive. Instead of associating bonds primarily with the presumption of safety as has long been the practice – it would be sounder to start with what is not presumption but fact, viz., that a bond is an investment with limited return. The essence of proper bond selection consists, in obtaining specific and convincing factors of safety in compensation for the surrender of participation in profits. Since the chief emphasis must be placed on the avoidance of loss, bond selection is primarily a negative art – process of exclusion and rejection. Broadly speaking, there is no such thing as being unduly cautious or exacting in the purchase of fixed value investments.

Four additional principles for selection of individual bonds:

1.    Safety is measured not be specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.

2.    This ability should be measured under conditions of depression rather than prosperity.

3.    Deficient safety cannot be compensated for by an abnormally high coupon rate.

4.    The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statute to govern investments of savings banks.

Principle 1: Safety Not Measured by Lien but by Ability to Pay

The primary emphasis must be the strength and soundness of the obligor enterprise. The older view of emphasis on the assets backing the bond does not work in practice due to

a)    The shrinkage of property values when the business fails – Properties are rarely adaptable to uses other than those for which they were constructed. Hence, if enterprise fails, its fixed assets ordinarily suffer an appalling shrinkage in realizable value. The value of pledged assets assumes practical importance only in the event of a default, and in such an event the book figures are almost invariably found to be unreliable and irrelevant.

b)   The difficulty of asserting the bondholders supposed legal rights – Courts reluctant to permit bondholders to take over properties by foreclosing if there is any possibility that these assets may have a fair value in excess of their claim.

c)  The delays and other disadvantages incident to a receivership – More valuable the pledged assets the longer the time it requires to work out an equitable division of value between various bond and stock issues.

Basic principle is to avoid trouble and not to protect himself in the event of trouble. Corollaries of this principle:

                       i.        Absence of lien is of minor consequence

                             ii.        Buy the highest yielding obligation of a sound company – select a company meeting every test of strength and soundness, and then purchase its highest yielding obligation, which would usually mean its junior rather than its first lien bonds

                            iii.        Senior liens are to be favored, unless the junior obligations offer a substantial advantage

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