Avoiding Risky Traditional Securities and New Issues

Key Insight

Enterprising investors should base their portfolios on high-grade bonds and reasonably priced common stocks, venturing into other securities only with clear justification. Key negative guidelines include avoiding high-grade preferred stocks (unless bought by corporations) and inferior bonds or preferred stocks, unless they are at bargain levels, typically meaning prices at least 30% below par for high-coupon issues. Investors should also shun foreign-government bond issues, despite attractive yields, and exercise caution with all new issues, including seemingly tempting convertible bonds and preferreds, and common stocks with only recent excellent earnings. For standard bond investments, choosing between high-grade taxable issues, yielding about 7.25% in late 1971, and good-quality tax-free bonds, yielding up to 5.30% on longer maturities, is recommended.

Buying second-grade issues solely for higher returns is ill-advised when first-rate corporate bonds yield 7.25% or more, as was possible in late 1971. Corporations with poor credit often resort to convertible bonds or warrants, meaning most inferior nonconvertible bonds are older issues selling at a large discount, offering potential principal gains under favorable conditions like improved credit rating or lower interest rates. Examples of deeply discounted obligations from 1970 include American Telephone and Telegraph 2.625s, due 1986, selling at 51; Atchison Topeka and Santa Fe RR 4s, due 1995, at 51; and McGraw-Hill 3.875s, due 1992, at 50.5. It is unwise to purchase bonds or preferreds lacking adequate safety merely for an attractive yield, especially at full prices (near 100), as experience shows these are highly susceptible to severe price declines and suspended payments during bad markets, often disproportionately more than common stocks.

Foreign government bonds have a poor investment history since 1914, marked by two world wars and a deep depression. Despite this, new foreign issues are frequently sold at par, indicating a flaw in average investor behavior. Owners of foreign obligations lack legal means to enforce claims if problems arise, as illustrated by the Republic of Cuba 4.5s, which traded as high as 117 in 1953, defaulted interest, and fell to 20 cents in 1963; and Czechoslovakia's 8% bonds, which saw extreme volatility from 96.5 in 1922 to 8 in 1970. All new issues generally demand extreme caution due to specialized salesmanship and being launched under market conditions favorable to the seller, not the buyer. While high-grade issues might result in only unpleasant rather than serious effects for buyers, lower-grade new issues, particularly common stock flotations during bull markets, frequently lead to substantial losses, with many losing 75% or more of their offering price, as seen in examples like Aetna Maintenance Co. (from $9 to $0.875) and AAA Enterprises (from $14 to 25 cents).