WS: INTELLIGENT INVESTOR VIII

INTELLIGENT INVESTOR VIII

Stock Selection for the Defensive Investor

It is time to turn to some broader applications of the techniques of security analysis. Since we have already described in general terms the investment policies recommended for our two categories of investors (defensive and enterprising), it would be logical for us not to indicate how security analysis comes into play in order to implement these policies.

Graham recommends here that a defensive investor choose between two approaches:
(1) essentially buying a low-cost index fund, which will assure one gets a market return with minimal effort, or
(2) apply a set of standards to each stock purchase in order to improve your odds of beating the market. He recommends these stock screens...


1. Adequate Size of the Enterprise

Graham's idea here is to exclude small companies which may be subject to more than average volatility (or illiquidity, or neglect). He does not that there will often be good opportunities in smaller stocks, but this is probably not for the "defensive" investor. In 1973, he recommended not buying stocks with less than US$100 million in sales and $50m in assets.

2. A sufficiently Strong Financial Condition

For industrial companies, Graham looked for current assets to be at least twice current liabilities (current ration >2). Also, long-term debt should not exceed the net current assets (or "working capital").

3. Earnings Stability

Positive earnings in each of the last ten years.

4. Dividend Record

Uninterrupted dividend payments over the last twenty years.

5. Earnings Growth

A minimum increase of at least one-third (33%) in per share earnings (EPS) in the past ten years using three-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio

Current stock price should not be more than 15 times average earnings of the past three years (historical PE < 15).

7. Moderate Ratio of Price to Assets

Current price should not be more than 1.5 times book value. However, a PE < 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, Graham suggests that the product of the PE x (ratio of price to book) = < 22.5 (which again corresponds to a stock price that is 15 times earnings and 1.5 times book value).


Ben Graham set up these stock screens especially for the needs and "temperament" of a defensive investor. They are designed to eliminate most stocks from an investor's radar screen by excluding companies that are
(1) too small,
(2) in relatively weak financial condition,
(3) with a deficit stigma in their ten-year record, and
(4) not having a long history of continuous dividends. Obviously, looking at 10- to 20-year track records is easier in the mature markets of the USA and Europe, but probably too restrictive in the young markets of Asia... nonetheless, the concept remains sound.

Selectivity for the Defensive Investor

Every investor would like his portfolio to be better or more promising than the market average. Hence the reader will ask whether, if they seek out a competent advisor or analyst, they should not be able to count on accumulating a winning portfolio. "After all," one may say, "the rules Graham has outlined above are pretty simple and easygoing. A highly trained analyst ought to be able to use their skills to improve substantially on an index basket of stocks. If not, what good are all their statistics, calculations, and pontifical judgments?"

Graham decides at this point to devise a practical test by asking 100 security analysts to choose the "best" 5 stocks in the 30-stock Dow Jones index to be purchased (in 1970). He predicts few would come up with identical lists, and many would have no overlap at all.

Graham doesn't find this surprising as it may first appear. The underlying reason is that the current price of each prominent stock pretty well reflects the salient factors in its financial record plus the general opinion as to its future prospects. Hence the view of any analyst that one stock is better than the rest must arise to a great extent from his or her personal partialities and expectations, or from the placing of emphasis on one set of factors rather than on another during their evaluations. If all analysts agreed that a particular stock was better than the rest, that stock would quickly soar to a price that would offset its previous advantages.

Graham's statement that the current price reflects both known facts and future expectations was intended to emphasize the double basis for market valuations. Corresponding with these two kinds of value elements are two basically different approaches to stock analysis. To be sure, every competent analyst looks forward to the future rather than backward to the past, and realizes that their work will prove good or bad depending on what will happen and not on what has happened. Nevertheless, the future itself can be approached in two different ways, which may be called the way of prediction (or projection) and the way of protection.

Those who emphasize prediction will try to anticipate fairly accurately just what the company will accomplish in future years-- in particular whether earnings will grow rapidly and consistently. These conclusions may be based on a very careful study of such factors as supply and demand in the industry-- or volume, price and costs-- or else they may be derived from a rather naive extrapolation from past growth into the future. If these authorities are convinced that the fairly long-term prospects are unusually favorable, they will almost always recommend the stock for purchase without paying too much attention to its current price.

By contrast, those analysts who emphasize protection are always especailly concerned with the price of the stock at the time of study. Their main effort is to assure themselves of a substantial margin of present value above the market price-- a margin large enough to absorb any unfavorable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company's long-run prospects as it is to be reasonably confident that the enterprise will get along.

The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under teh heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth. Incidentally, the quantitative method is really an extension-- into the field of common stocks-- of the viewpoint that security analysis has found to be sound in the selection of bonds and preferred stocks for investment.

In Graham's own attitude and professional work was always committed to the quantitative approach. From the first he wanted to make sure that he was getting ample value for his money in concrete, demonstrable terms. He was not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand. This has by no means been the standard viewpoint among investment authorities; in fact, the majority would probably subscribe to the view that prospects, the quality of management, other intangibles, and "the human factor" far outweigh the past performance records, the balance sheet, and all other cold figures.

Thus this matter of choosing the "best" stocks is a controversial one. Graham's advice to the defensive investor was that he let it alone. Let him emphasize diversification more than individual stock selection (buy an index fund). Incidentally, the universally accepted idea of diversification is, in part at least, the negation of the ambitious pretensions of selectivity. If one could select the best stocks unerringly, one would only lose by diversifying. Yet within the limits of the four most general rules of common-stock selection suggested for the defensive investor there is room for a rather considerable freedom of preference. At the worst the indulgence of such preferences should do no harm; beyond that, it may add something worthwhile to the results. With the increasing impact of technological developments on long-term corporate results, the investor cannot leave them out of his calculations. Here, as elsewhere, he must seek a mean between neglect and overemphasis.


Credits: This article is extracted (with substantial modifications) from Ben Graham's 1973 edition of The Intelligent Investor, Chapter 14.

POSTED :19 Jun 2006