Security Analysis Chapter 6 Summary

Reading: Chapter 6 - The Selection of Fixed-Value Investments

One Minute Summary:

The chapter gives an overview of different types of fixed-value investment.

1. “High-grade straight bonds and preferred stocks.”

2. “High-grade privileged issues, where the value of the privilege is too remote to count as a factor in selection.”

3. “Commons stocks which through guaranty or preferred status occupy the position of a high-grade senior issue.”

In addition, the chapter outlines four principles for the selection of fixed-value issues.

1. “Safety is measure not by 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.”

Chapter in Detail:

When purchasing a bond, the primary focus should be the enterprise’s earning power and not on the promise and protection of the bond. Bond buyer should take similar approach as equity investors to identify the soundness of the issuing enterprise and exclude bonds that do not meet the standards of safety.

The chapter proposes four principles for selecting individual bonds (see the section above) and focuses on the first principle—“Safety not measured by lien but by ability to pay.” The lien itself is insufficient to make a sound purchase in a bond based on the following reasons:

1. The pledged properties are rarely adaptable to other form of business uses; therefore, should the enterprise failed itself, the pledged assets are likely to suffer a significant drop from its appraised value.

2. The bond holders rarely own the actual pledged assets, unless the realizable value is substantially less what the holders are entitled to. Most of the time, the bond holders took new securities of the reorganized enterprise with a lesser value.

3. Bond holders have to wait for a long period of time during the receivership for the property to foreclose, and an even longer period of time to receive his or her shares among different classes of bond and stock holders. The bond holders are likely to face a significant depressed quoted value for the duration of the receivership and an uncertain outcome to the final disbursement.

Consequently, the chapter offers following position in regard to bond selection:

1. Purchase should focus on an enterprise with plentiful resources to meet its interest payments, even if the bond itself has a lower priority and is less secured than a higher secured bond in a weak enterprise.

2. Identify an enterprise that meets every test of financial strength and soundness, and then select the highest yielding bond offered by that enterprise—this would usually imply selecting the junior rather than the first lien bonds.

3. Among different enterprises, bonds with senior liens should be preferred when the yield among all class of bonds are similar. Junior issues should be considered when they have a substantial yield advantage or asset protection compared to other enterprises based on the following conditions:

a. The protection for the total debt of the issuing enterprise is more than sufficient.

b. The protection for the total debt of the issuing enterprise is considerably higher than senior bonds in other enterprise with similar yields.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:

Underlying Bonds—small size bonds that are secured by a lien on an especially important component of the issuer’s business system. Historically, the railroad industry usually issued this kind of bond. Currently, some underlying bonds are issued as a first lien on mortgage claims.

Additional thoughts:

Bonds in receivership should be considered even if the timing is uncertain, given the facts that the enterprise can fulfill its commitments after reorganization.

Practical Application:

1. The Seaboard-All Florida Railway (Seaboard) First Mortgage 6s—this example was used to illustrate that lien is no guarantee against shrinkage in the value of the pledged asset. The bond, which originally sold for $25 million at 98 1/5 in 1925 and due in 1935, had a first lien on approximately 475 miles on newly constructed and finished lines. Seaboard went into receivership in 1931, and the bond was selling as low as 1 cent on the dollar. The bond had raised its market value to 3.875 cents on the dollar at the end of 1939.

Three Quotes:

1. “Soundness of the best investment must rest not upon legal rights or remedies but upon ample financial capacity of the enterprise.”

2. “It is a process of exclusion and rejection, rather than of search and acceptance. In this respect the contrast with common-stock selection is fundamental in character. The prospective buyer of a given common stock is influenced more or less equally by the desire to avoid loss and the desire to make a profit.”

3. “But neither priority nor promise is itself an assurance of payment. This assurance rests in the ability of the enterprise to fulfill its promise, and must be looked for in its financial position, record, and prospects.”

Three questions to the group to test understanding:

1. What are the differences between bond and equity in terms of return and safety?

2. What is a debenture, why should it be considered?

3. What is the difference between straight bonds and preferred stocks?

Clarifications & Group Discussion:

· “The value of the pledged property is vitally dependent on the earning power of the enterprise,” would you agree or disagree?

· Why has corporate bonds been neglected among retail investors as an individual investment candidate?

· When should we consider switching between fixed value investments and equity investments?