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Chapter 41: Low Priced Common Stocks. Analysis of the Source of Income

·         In the securities market it is commonplace that an issue will rise more readily from 10 to 40 than from 100 to 400. This fact is due in part to the preferences of the speculative public, which generally much more partial to issues in the 10-40 range.

·         The profound liking of public  for “cheap stocks” would seem to have sound basis in logic. Yet most people who buy low priced stock lose money. This is because the public buys issues that are sold to it, and the sales effort is put forward to benefit the seller and not the buyer. In consequence, the bulk of the low priced purchases made by the public are of the wrong kind.

·         A genuinely low priced common stock will show an aggregate value for the issue which is small in relation to the company’s assets, sales and past or prospective profits.

·         Observations of the stock market will show that the stocks of companies facing receivership are likely to be more active than those which are very low in price because of poor current earnings. This is caused by desire of insiders to dispose off the holdings before the receivership wipes them out. But where a low priced stock fulfills our conditions of speculative attractiveness, there is apt to be no pressure to sell and no effort to create buying.

·         Low price coupled with speculative capitalization: Speculatively capitalized enterprises, are marked by a relatively large amount of senior securities and a comparatively small issue of common stock. Even if there are no senior securities, the common stock may have possibilities equivalent to those in a speculatively capitalized enterprise when market value of the common stock represents a small amount of money in relation to the size of the business, regardless of how it is capitalized. Large rental charges or other such fixed costs are equivalent in good part to senior securities.

§  The speculative or marginal position may arise from any cause that reduces the percentage of gross available for the common to a subnormal figure and that therefore serves to create a subnormal value for the common stock in relation to the volume of business. Unusually high operating or production costs have the identical effect as excessive senior charges in cutting down the percentage of gross available to common.

§  An inverse relationship usually exists between profit per unit and output per dollar of stock value. Company A which has 7 cent cost sells at a higher price pound of output than Company C with its 9 cent cost.

s  This gives rise to speculative technique: When a rise in the price of the commodity occurs, there will ordinarily be a larger advance, percentagewise, in the shares of high cost producers than in the shares of low cost products.

s  Contrary to general impression in Wall Street, the stocks of high cost producers are more logical commitments than those of the low cost producers when the buyer is convinced that a rise in the price of the product is imminent and he wishes to exploit this conviction to the utmost.

·         Graham suggests that the source of income be studied in relation to specific assets owned by the company, instead of in relation merely to the general nature of the business. This may be quite important when a substantial portion of the income accrues from investment holdings or from some other fixed and dependable source.

§  Income derived from large bond holdings would be valued at a different multiplier than from the operations.

Situations of this kind arise with sufficient frequency to make this a worthwhile pursuit.
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