WS: INTELLIGENT INVESTOR IV

INTELLIGENT INVESTOR IV

Defensive Investors and Stocks

Ben Graham loved to sit back and analyze stock market historical trends... not to gain an advantage in 'timing' the market, but to gain a healthy perspective about whether current stock prices represented a high probability of positive future returns, or a low probability. Here is how he analyzed the situation (including much irony and paradox in how markets move and are viewed) in his final edition of The Intelligent Investor, looking back from the early 1970s...

In our first edition (1949) we found it necessary at this point to insert a long exposition for the case for including a substantial common-stock component in all investment portfolios. Common stocks were generally viewed as highly speculative and therefore unsafe; they had declined fairly substantially from the high levels of 1946, but instead of attracting investors to them because of their reasonable prices, this fall had had the opposite effect of undermining confidence in equity securities. We have commented on the converse situation that has developed in the ensuing 20 years, whereby the big advance in stock prices made them appear safe and profitable investments at record high levels which might actually carrry with them a considerable degree of risk.

The argument we made for common stocks in 1949 turned on two main points. The first was that they had offered a considerable degree of protection against the erosion of the investor's dollar caused by inflation, whereas bonds offered no protection at all. The second advantage of common stocks lay in their higher average return to investors over the years. This was produced both by an average dividend income exceeding the yield on good bonds and by an underlying tendency for market value to increase over the years in consequence of the reinvestment of undistributed profits.

While these two advantages have been of major importance-- and have given common stocks a far better record than bonds over the long-term past-- we have consistently warned that these benefits could be lost by the stock buyer if he pays too high a price for his shares. This was clearly the case in 1929, and it took 25 years for the market level to climb back to the ledge from which it had abysmally fallen in 1929-2932. Since 1957 common stocks have once again, through their high prices, lost their traditional advantage in dividend yield over bond interest rates. It remains to be seen whether the inflation factor and the economic-growth factor will make up in the future for this significantly adverse development.

It should be evident to the reader that we have no enthusiasm for common stocks in general at the 900 DJIA level of late 1971. For reasons already given we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even if he must regard them as the lesser of two evils-- the greater being the risks attached to an all-bond holding.

Rules for the Common-Stock Component

The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we could suggest four rules to be followed:

1. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.

2. Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.

3. Each company should have a long record of continuous dividend payments. (Graham recommended >20 years!)

4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years (PE ratio). We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. In particular, it would ban virtually the entire category of "growth stocks," which have for some years past been the favorites of both speculators and institutional investors. We must give our reasons for proposing so drastic an exclusion.

Growth Stocks and the Defensive Investor

Ther term "growth stock" is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future. (Some authorities would say that a true growth stock should be expected at least to double its per-share earnings in ten years-- i.e., to increase them at a compounded annual rate of over 7.1%) Obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive. The problem lies there, of course, since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period. This has introduced a speculative element of considerable weight in the growth-stock picture and has made successful operations in this field a far from simple matter.

The leading growth issue has long been International Business Machines (IBM), and it has brought phenomenal rewards to those who bought it years ago and held on to it tenaciously. But we have already pointed out that this "best of common stocks" actually lost 50% of its market price in a six-months' decline during 1961-62 and nearly the same percentage in 1969-70. Other growth stocks have been even more vulnerable to adverse developments; in some cases not only has the price fallen back but the earnings as well, thus causing a double discomfiture for those who owned them. A good second example for our purpose is Texas Instruments, which in six years rose from 5 to 256, without paying a dividend, while its earnings increased from 40 cents to $3.91 per share. (Note that the price advanced five times as fast as the profits; this is characteristic of popular common stocks.) But two years later the earnings had dropped off by nearly 50% and the price by four-fifths, to 49.

The reader will understand from these instances why we regard growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor. Of course, wonders can be accomplished with the right individual selections, bought at the right levels, and later sold after a huge rise and before the probable decline. But the average investor can no more expect to accomplish this than to find money growing on trees. In contrast we think that the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, offers a sound if unspectacular area of choice by the general public.


Credits: This article, with adaptations and additions, is extracted from Ben Graham's 1973 version of The Intelligent Investor, Chapter 5.

POSTED :09 Jun 2006