Stock Selection for the Defensive Investor
This is the fourteenth 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 thirteenth chapter, which compared four different companies utilizing some of Graham’s techniques. This week we will discuss the fourteenth chapter, which is titled “Stock Selection for the Defensive Investor.” 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!
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 throughout the book club, so keep it up!
We are now at the heart of the book, and this chapter along with the next chapter are the two which have influenced ModernGraham the most. This site as a whole is all about modernizing Graham’s techniques primarily found in these two chapters, and then implementing those techniques in analysis of individual securities. The chapter we’re discussing this week deals directly with the Defensive Investor’s requirements and the next chapter deals with the Enterprising Investor’s requirements. Let’s take a look at each of the Defensive Investor’s requirements, and how I have modernized them here at ModernGraham:
1. Adequate Size of the Enterprise – Graham expressly says that “our idea is to exclude small companies which may be subject to more than average vicissitudes” and when he wrote the book in the early 1970s he required sales of not less than $100 million for industrial companies or $50 million in assets for a public utility. Of course, inflation has grown the overall size of companies, and I have updated this requirement to expect that Defensive Investor companies have at least $2 billion in market capitalization (stock price x outstanding shares).
2. A Sufficiently Strong Financial Condition – Graham’s requirements were for industrial companies to have a current ratio of 2 or higher and not have long-term debt exceed net current assets. Graham also allowed public utilities to skip the current ratio requirement but instead required them to not have debt exceeding twice the stock equity. I’ve made a couple of changes in this area. First, financial companies are not required to pass this test, but they are then required to pass every other Defensive Investor requirement. Second, the current ratio requirement presently applies to any type of company, not just “industrials.” This allows the investor to have a stable basis of analysis to utilize when comparing to other companies in any industry. At this time, I do not make any special allowances for public utilities, which admittedly leads to most of them failing the requirements; however, public utilities are one area where I am seriously considering making further changes to the ModernGraham approach. I just don’t quite know what the best way to handle utilities is yet.
3. Earnings Stability – Graham required positive earnings for at least the last ten years. So does the ModernGraham approach.
4. Dividend Record – Graham suggested consistent dividend payments for 20 consecutive years, but I have lowered that to ten years. The primary reason is that I find if a company has been around for a long time and has consistently paid dividends for 10 years, it is just as likely to pay them in the future as any company that has paid them consistently for 20 years. Having a 20 year requirement would only serve to eliminate companies that have not been around for 20 years, which would knock out many solid but young enterprises.
5. Earnings Growth – Graham required an increase by 1/3 in earnings per share in the last ten years based on 3-year averages from the first three years and the last three years. ModernGraham has not changed this requirement for Defensive Investors.
6. Moderate Price/Earnings Ratio – Graham initially states that the “current price should not be more than 15 times average earnings of the past three years” but then later explains that the 15x figure is based on the prevailing high-grade bond rate at the time. To be more precise, Graham says “our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio – the reverse of the P/E ratio – at least as high as the current high-grade bond rate.” The ModernGraham approach requires a P/E ratio of no more than 20, which corresponds to a bond yield of 5%. This generally seems like a conservative level based on the current bond market.
7. Moderate Ratio of Price to Assets – Graham required either the price to book ratio be less than 1.5 or the product of the price to book times the P/E ratio be less than 22.5 (calculated by taking his P/E ratio requirement of 15 or less times the 1.5 P/B ratio). I have increased the P/B ratio level to 2.5 because Graham’s requirement proved too restrictive in the market today. At 2.5, it is still a reasonably restrictive requirement without completely narrowing down the Defensive Investor’s options. The corresponding alternative way of satisfying this requirement, that of multiplying the P/E and P/B ratios, has therefore also increased to 50 (20 times 2.5).
For the first time in about ten chapters, I had the luxury of being able to read this chapter within shouting distance of Ben. Perfect timing too, as this chapter is the core of the Modern Graham analysis and I had plenty of questions to ask.
First, if you’re looking for the brief synopsis, I’d recommend reading Graham’s 1-7 point summary on page 348-349 (just a few pages in). Here he lists the main things tests that a defensive investor should require their companies to pass. One thing to note, however, is that time has necessitated some changes. For example, I noticed that Graham selects “industrial companies” and “utility companies”, which today leaves out a great number of companies. The Modern Graham analysis excludes financial companies from the necessity of passing the current ratio requirement and as a whole requires companies to meet 6/7 tests.
Graham uses these seven points to conduct several real-world analyses. What I found most compelling about these was the relationship between the DJIA as a whole and as individual stocks. While the whole meets the qualifications set forth in the seven points, only five would meet all requirements. This analysis gives extremely strong evidence to support diversification.
One of my favorite quotes from this chapter is from the commentary where Zweig notes “But diversification doesn’t just minimize your odds of being wrong. It also maximizes your chances of being right.” I love this quote because it reminds me that diversification is not just about reducing the impact of bad stock, but ensuring that we buy the good ones.
Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.
- What quote from this chapter do you think best summarizes the point Graham is making?
- What do you think of Graham’s original requirements for Defensive Investors? Do you agree with the changes I’ve made for the ModernGraham approach?
- Are there any other “modernizations” you would make to Graham’s requirements?
- What did you think of the chapter overall?
Next Week’s Discussion: Chapter Fifteen
Chapter Title – Stock Selection for the Enterprising Investor
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!