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The Defensive Investor and Common Stocks (MG Book Club Chapter Five)

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The Defensive Investor and Common Stocks

This is the fifth discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link).  In last week’s discussion, we discussed the fourth chapter, which outlined the general allocation of the Defensive Investor’s portfolio, paying particular attention to the division between equities and bonds.  This week we will discuss the fifth chapter, which is titled “The Defensive Investor and Common Stocks”  I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor.  Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!

In this chapter, Graham outlines four basic rules for Defensive Investors to follow, keeping in mind the Defensive Investor is one who is not willing to spend much time on analyzing investment opportunities.  He then goes on to elaborate on the reasons behind the rules and some basic investing strategies for the Defensive Investor.  The rules are as follows:

  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.
  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.  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.

Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by another commentator interesting, feel free to respond to them with another comment.  We’ve had some great discussions the last few weeks, so keep it up!

ModernGraham’s Comments

Ben

I think this chapter outlines some of the most important requirements for the Defensive Investor.  In later chapters, Graham provides the specific requirements for the investor types, but here he provides the initial suggestions.  It is very interesting to note a couple of things about his requirement of diversification.  First, he wrote this years before “modern portfolio theory” and the Capital Asset Pricing Model were developed, which are the basis today behind the notion of diversifying in order to minimize risk.  Second, though he suggested a minimum, he also suggested a maximum number of stocks to be held in a portfolio.  One other key concept I note from the four rules is the requirement of a maximum P/E multiple.  Graham specifically suggests requiring a company trade at below 25 times the average earnings over the last seven years, or at below 20 times the past year average.

After discussing the basic rules for Defensive Investors, Graham suggests the Defensive Investor re-analyze all investments on at least an annual basis to determine if they still meet the requirements.  This is key also, because on occasion, a company’s financial position may change and it may become less attractive or less stable.  At that time, it may be important for the Defensive Investor to move his funds to another opportunity.  However, Graham suggests that if the Defensive Investor has followed the rules to begin with, there should not be any “need for frequent or numerous changes.”

Heather 

Chapter five follows a similar formula to chapter four’s discussion on bonds, expounding on the important aspects of stock purchasing. In this chapter, Graham lays out the four step process to stock buying, that should feel very familiar to ModernGraham readers as it is the basis for our analysis.  I value Graham’s time spent of the psychology of investing this chapter as it was yet again a helpful reminder that investing is not isolated from the rest of our life. The risk we take in buying stock needs to be carefully weighed with the risks that we are willing to take as well as the amount of time that we are willing to spend researching the company.

In Zweig’s commentary, he brings up the point of “buy what you know” and how this is often where people begin and end. I see this all too often with people that I know, such as a relative who bought Facebook stock immediately after its initial offering because he knew of the popularity. We see it with ModernGraham as well, when posts about companies like Amazon bring in thousands of page hits, and lesser known (and often better companies) barely register with readers. Zweig counters this statement by reminding us that the closer we are to something, the harder it is to see the truth. For companies such as Facebook, Twitter, and Apple, which have a daily presence in our lives, it is easy to get lost in the popularity and forget that presence does not equal profit.

Last, Graham’s explanation of Dollar-Cost Averaging resonated with me immensely. In Ben and my marriage we have found the best way to handle our finances is if I budget for the monthly spending and Ben address all long term planning. For years he’s been asking me to budget for a monthly addition to our investments and I’ve never managed to get around to doing so. It isn’t that investing isn’t important to me, rather I never realized how important it is to make additions part of your monthly routine and not just haphazardly when the timing feels right. After reading this chapter, I’m completely sold on adding money to our investments monthly. As I type this, Ben is on his computer making the arrangements to have our investment account automatically withdrawal from our checking account every month. Perhaps I should have read Chapter 5 sooner.

Discussion Questions

Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.

  1. What quote from this chapter do you think best summarizes the point Graham is making?
  2. What do you think of Graham’s general rules for Defensive Investors?
  3. How many companies do you have in your portfolio today?
  4. How can we balance “buying what we know” with the neutrality that is needed for proper research?
  5. Do any of you experience differences of opinion with your partner about investing? How do you handle those situations?
  6. What did you think of the chapter overall?

Next Week’s Discussion: Chapter Six

Chapter Title – Portfolio Policy for the Enterprising Investor: Negative Approach

When reading the next chapter, try to think about how the concepts Graham presents in the chapter could apply to your own investments, whether you consider yourself a Defensive Investor or an Enterprising Investor.

What are some other ways to participate?

If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.

In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!

14 thoughts on “The Defensive Investor and Common Stocks (MG Book Club Chapter Five)

  1. 1. Quote: “If a group of well-selected common-stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not, it will sell for awhile under the buyer’s cost. If that fact makes the investment “risky”, it would then have to be called both risky and safe at the same time.”

    2. Graham’s Rules:
    #1. 10-30 stocks. Totally agree.More than 30 stocks in a portfolio would be too many for me to adequately follow on a quarterly basis. Less than 10 stocks in a portfolio does not provide me adequate diversification against my own imperfections in stock selection.
    #2. Large, prominent, conservatively financed. Completely agree. Large and prominent emerged from successful and profitable operations. I sleep better placing my capital with a proven performer rather than just a hope or promise. Conservatively financed company earnings suffer less in recessionary periods than earnings of higher leveraged companies within the same industry. Stable earnings help support stable dividends and stable dividends help support my stable expenses in life.
    #3 Long history of stable dividends. I live on these dividends and long history of increasing dividends are even better than stable dividends.
    #4. Purchase price limit of 20x average 7yr earnings or 25x TTM earnings. These P/E ratios are way too high for me as a purchase price. Peter Lynch recommends to purchase at prices below P/E of 15 which is an earnings yield of 6.7%. No thanks, my limit is more like P/E of 12 or less to make a purchase. Elsewhere Graham uses 3 year average earnings and sets a limit of P/E at 12 if P/TB is not greater than 1.5 or the product of the two does not exceed 22.5. P/E of 12 equates to a earnings yield of 8.3% and is a little more in line with S&P 500 growth rate over its history.

    3. How many stocks. The individual stock portion of my portfolio currently contains 10 stocks. My ideal number of stocks would be 15-20 and am working to get there but current market prices are not helping me with this. So I wait patiently for a correction, hoping it will produce some opportunities for me.

    4. Neutrality vs knowledge. I may not understand the question here but I don’t think there are trade-offs required in order to arrive at a balanced position. I buy stocks in industries that I have a working knowledge of. Within those industries I buy stocks that I understand and agree with how they make money. For example, I understand how diversified tobacco companies make money but I don’t like how they make money, so I don’t even consider owning them. So my knowledge base gives me the universe of stocks I will consider selecting from and my neutrality is achieved (I hope) from logical fact based analysis.

    5. Partner dynamics. My partner, my wife, likes the dividends she gets but is not interested in making investment decisions. So as long as the dividend stream is steadily increasing over time she is happy. If that stream of income started decreasing she would most certainly let me know and start digging deeper into my investment decisions (or so I would hope).

    6. Great chapter if you don’t hold Graham fast to his stated numbers. It is his concepts that are sound as a rock.

    1. Richard, thanks as always for contributing to the club’s discussion. I typically agree that the lower the PE the better, though I think in some limited cases of strong demonstrated growth the higher PE may be justified.

  2. 1.What quote from this chapter do you think best summarizes the point Graham is making?

    “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.” Pg. 116. The two paragraphs preceding this statement gave examples of the volatile nature of growth stocks. The defensive investor doesn’t have the time to continuously monitor his positions.

    2.What do you think of Graham’s general rules for Defensive Investors?

    I thought his rules were well thought out and sound. Actually I appreciate that he took the time to list these rules for people who wish to maintain a safety of principle and receive a satisfactory return.

    3.How many companies do you have in your portfolio today?

    25

    4.How can we balance “buying what we know” with the neutrality that is needed for proper research?

    Through discipline. I’ve make this same mistake myself earlier – buying what I know without researching the financials. I have to restrain my emotions and force myself to do my research before buying. I’m getting better about this though.

    5.Do any of you experience differences of opinion with your partner about investing? How do you handle those situations?

    Not yet. I’ve only been married a couple of years and she spends every dollar she gets.  I make the investment decisions. She is currently attending college working toward an accounting degree. I already have an engineering degree but I when back this semester and am taking a financial statement analysis class. It’s nice to take a class I want to, instead of a class I have to.

    6.What did you think of the chapter overall?

    I feel Graham is spelling out the basics for a defensive portfolio and his reasoning behind his conservative approach for this type of investor. Also I think he gave good examples of why you have to be honest with yourself and decide if you really have the time to be an enterprising investor. Right now I’m regrouping and focusing on a defensive approach until I know I have the knowledge and time to expand my approach.

    1. Rooster, thanks for the comments! I’m sure with time you will gain the confidence in your research. Just keep in mind that the risk level you accept should not be based on your expectation of return but rather on the amount of effort you are willing to put in to the research.

  3. 1. What quote from this chapter do you think best summarizes the point Graham is making?
    In referring to growth stocks “Obviously stocks of this kind are attractive to buy and to own, provided the price 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.”
    2. What do you think of Graham’s general rules for Defensive Investors?
    I think for the most part Graham’s reasoning is sound. However, if someone has very little time to spend on stocks, why not invest in ETFs?
    3. urrently I have 4 stocks in my portfolio, but I also own 5 ETFs spread out in asset size and category.
    4. How can we balance “buying what we know” with the neutrality that is needed for proper research?
    I think we should use checklist in order to go through the same level of analysis for each investment. We should set minimum standards and not deviate.
    5. Do any of you experience differences of opinion with your partner about investing? How do you handle those situations?
    N/A
    6. What did you think of the chapter overall?
    I liked 3 things:
    –There are two primary reasons stocks are better than bonds; a. inflation protection; b. ROI.
    –Large and unfashionable firms may have a low P/E so they are good investments.
    –Dollar cost averaging is a great way to go.

    1. Mark – in regard to your comment about ETFs, I posit that the truly defensive investor would ultimately choose to go the ETF route due to its ability to be a sound option for the truly passive investor. However, I think the concepts Graham provides for Defensive Investors are best suited for investors that are interested in doing at least some research into individual companies, though still not enough research to be considered an Enterprising Investor.

      1. I agree Ben. Graham would think, much like Buffett does, that ETF’s are for a totally passive investor- not a defensive investor.

  4. 1) There are many quotes from this chapter that I liked, but the following quote I think highlights the general mindset of Graham best,”… the bona fide investor does not lose money merely because the market rice of his holdings declines; hence the fact that a decline may occur does not mean that he is running a true risk of loss. If a group of well selected common-stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer’s cost. If that fact makes the investment “risky,” it would then have to be called both risky and safe at the same time. This confusion may be avoided if we apply the concept of risk solely to the loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position – or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.”
    2) I feel the simplicity of the rules for the Defensive Investor is great. First off, as a defensive investor, you need diversification – only the best enterprising investor like Buffet should concentrate his portfolio. The next idea that the company needs to be of a prominent size and financial structure helps you stay out of companies that may have not run wisely with respect to their finances. In the third requirement Graham requires the defensive investor to buy a company that pays a dividend.
    I see this as very important, but if the company is retaining its earning and building reserves, this seems like a good reason to consider a company that is not paying a dividend – the investor gets to avoid a tax liability until the investor decides to liquidate and capture a capital gain at their optimal time. Lastly is the idea of a limit in the price you should pay, and this is one of the criteria of intrinsic value – limit of 25 times average earnings and this keeps you out of growth stocks.
    3) I have a mix of companies and exchange traded funds. The companies that I own often hold many other companies, and they act as a mutual fund in essence. I hold a small 25% of my portfolio in individual companies. I am looking to diversify that 25% more broadly, and I hope to gain more insight to do that with this club.
    4) Buying what you know can be a bad thing when you purchase overpriced stocks because you are a biased fan of their products – you need to stay objective. I think knowing an industry or business type if a must, and that is where you should base your decision. It should never be because you simply like their products. The products might be good, but is the company operating well with respect to Grahams criteria in producing the “cool” products. I used to hate to hear the business pitch from my clients that they were producing the highest quality product/service for their industry, and that meant that they were only addressing the premium price point, and many small business person brushes of the medium and low price point product markets. Quality is great, but does the highest premium product make you the most profit was always in the back of my mind.
    5) My wife is super conservative, and our finances have been such that we needed to avoid risk. However, she looks very short run, and I am always working the long run into our conversation. I keep in mind the time value of money, and time is just as important as money in that calculation.
    6) This chapter starts to bring Grahams intrinsic value into focus. His four criteria for the defensive investor help build that framework. It seems that P/E and P/B are the corner stones of his criteria; does anyone else feel the same? This is the key to starting to objectively understanding the value of a company. I am a big fan of dollar cost averaging.

    1. John,
      Good question, and certainly P/E & P/B are significant measuring criteria for stock value. However, equally important, are the types of companies one is screening. I would label Graham’s statement in chapter 1, “The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition.” as his (and my) cornerstone for investing. Companies that fit this criteria then must have stock available at bargain prices in order to be an attractive investment. In other words, if a stock had a low P/E and P/B but was of a company that had only been in business less than ten years and or did not show steady profits for more than 10 years they would not qualify as an investment option for the intelligent defensive investor. Of Graham’s four rules for common stock investment, I think the most important are rules two and three. It is those rules which will keep the investor from incurring catastrophic loss with their investment. Over paying for a stock that meets the requirements in rules two and three will simply limit profit potential, but should not place the investor in danger of loosing principle in the long run. The dividend requirement Graham mandates in rule three is an important one. A stock’s dividend is commonly referred to as the canary in the coal mine. Just like the dying canary alerted the miners the air was becoming toxic, a company’s dividend-cut alerts investors that management sees trouble ahead for the company’s profits. Just some thoughts of an old man, hope they help.

      1. I am of the belief that there are a few steps to an analysis. Very briefly, here is the ModernGraham approach:

        1. Determine if the company is suitable for one’s particular investor type (Defensive or Enterprising). If so, continue. If not, then move on to another company.

        2. Determine if the company is trading below its intrinsic value. If so, continue. If not, move on to another company.

        3. Compare the company to other companies that have passed the first two steps, taking into consideration management efforts, brand value, moats, etc.

        4. Invest in only the companies that are undervalued, fit the proper investor type, and have the greatest prospects for success.

      2. Richard – Thank you for the reply. I agree that in general a dividend works well as a canary because it signals many things, and reducing a dividend is very negatively received by the market. However, as Buffett has remarked about paying dividends with Birkshire – it is good to leave the timing of the tax liability up to the shareholding owner. I am not personally looking for dividend income, and I like to find a company that is a good steward of their retained earnings. It is a balance of safety because of not having the dividend. I wonder what Graham and Buffet use to compensate for the risk of not having a dividend.

        1. Yes John, the use of retained earnings is a critical point. As long as a company can invest those retained earnings in a way that does not reduce their ROE, then they are making sound decisions with its use. If they are investing them in such a way that causes their ROE to diminish, then they are actually hurting the stock holders. In this case, I am sure Mr. Graham and Mr. Buffet would be finding an exit strategy for that investment. If the company can’t find a way to invest the retained earnings that is at least supportive of its ROE and just retains earnings as cash, building a cash hoard; this do-nothing option will reduce their ROE. In this case, the company should either buy back its own stock or return the earnings to the stock holders. However, if the market price of their stock is at a premium to its intrinsic value, the stock holders are better served by receiving taxable dividends to reinvest at their discretion. I think Mr. Graham and Mr. Buffet would agree with me in that I don’t want the company buying its own stock at a price higher than what I would pay for the stock. Additionally, any company that can’t find an ROE enhancing or sustaining use of retained earnings is a company that is no longer a good growth prospect.

  5. 1. What quote from this chapter do you think best summarizes the point Graham is making?

    This is a rather long quotation, but it also points out the four rules that Grahams suggests the defensive investor to follow to make the selection of common stocks a relatively simple matter.

    “The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would 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. Observations on this point are added at the end of the chapter.

    3. Each company should have a long record of continuous dividend payments. (All the issues in the Dow Jones Industrial Average met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.

    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. 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.”

    2. What do you think of Graham’s general rules for Defensive Investors?

    I like Graham’s general rules because they include important aspects regarding portfolio composition, companies with a favorable business and dividend payments history and also, maybe the most important thing, the aspect of how much to pay for a business average earnings.

    3. How many companies do you have in your portfolio today?

    Right now I have two companies in my portfolio. The remaining part of the portfolio is in cash, so I constantly look for great businesses at fair or great prices to buy to increase the number of companies. But at the moment I cannot say that there are a lot of companies that meet my requirements.

    4. How can we balance “buying what we know” with the neutrality that is needed for proper research?

    By constantly being aware heuristics and human biases that affect us in our daily life, especially in the daily life of an business analyst and investor.

    5. Do any of you experience differences of opinion with your partner about investing? How do you handle those situations?

    Not applicable to me at the moment.

    6. What did you think of the chapter overall?

    Great chapter. Graham makes everything sound so obvious. The four rules for the defensive investor and the discussion about growth stocks and the note on the concept of risk are all great reads.

    This post has also been published at http://hurricanecapital.wordpress.com.

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