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Chapter 8: Classification of Securities

Graham warns that the basis for classification is not the title of the issue, but the practical significance of its specific terms and status to the owner.

The following classification is suggested:

  1. Investment bonds and preferred stocks: Includes all issues, whatever the title, in which prospective change of value may fairly be said to hold minor importance. The owner’s dominant interest lies in the safety of his principal and his sole purpose in making the commitment is to obtain a steady income.
  2. Speculative bonds and preferred stocks: Prospective changes in the value of the principal assume real significance.
    1. Convertibles, etc.: The investor hopes to obtain the safety of a straight investment, with an added possibility of profit by reason of a conversion right or some similar privilege.
    2. Low grade senior issues: A definite risk of loss is recognized, which is presumably offset by a corresponding chance of profit. These differ from Group iii, in two respects – they enjoy an effective priority over some other junior issue, thus giving them a degree of protection and their profit possibilities, however substantial, have a fairly definite limit, in contrast with the unlimited percentage of possible gain associated with common stock investment.
  3. Common stocks

A bond of investment grade which happens to sell at any unduly low price would belong in the second group, since the purchaser have a reason to expect in an appreciation of its market price. A preferred stock selling at 10 cents on the dollar should be viewed not as a preferred stock at all but as a common stock.

The primary emphasis is not placed on what the owner is legally entitled to demand but on what he is likely to get or justified in expecting, under conditions which appear probable at the time of purchase.

Part II deals with Group (i), Part III deals with Group (ii) and Parts IV, V, VI deal with Group (iii).

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