The ModernGraham approach requires first determining what type of investor you are. It is assumed that you are an Intelligent Investor, as Benjamin Graham would put it, or in other words you seek to be patient and factually-based in your investing and has nothing to do with your actual IQ. However, Graham took it a step further and divided Intelligent Investors into two types: Defensive and Enterprising. I believe that distinction remains very important, and as a result the first step of the ModernGraham approach to investing is to screen companies according to investor type. Graham provided a number of criteria to use for stock selection for each investor type (discussed below), but I’ve made it a little easier for you. Each month I analyze over 1000 companies to determine which ones are suitable for Defensive Investors, and which ones are suitable for Enterprising Investors. The result is published in ModernGraham’s Premium Reports.
Defining Defensive Investors and Enterprising Investors
Benjamin Graham’s definition can be taken directly from the introduction to The Intelligent Investor (affiliate link):
In the past we have made a basic distinction between two kinds of investors to whom this book was addressed – the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.
In other words, the Defensive Investor is one who is not willing to take the time to do significant research into finding great value opportunities and will instead seek to avoid loss by investing in very stable companies. In contrast, the Enterprising Investor is willing to do further research and will work hard to find opportunity. Either investor type still seeks to avoid loss, but the primary difference is the amount of time the Enterprising Investor is willing to spend on his investing habits.
Today’s markets are a bit different from how they were in Graham’s day, primarily due to the use of computers. Since the digital age arrived, financial institutions have created more and more sophisticated investing techniques, and economists developed the concept of efficient markets. This has led to the availability of index funds, ETFs, and similar techniques, which are truly the most passive form of investing. I believe that the most defensive investors will seek to invest in index funds because of the ease at which it can be accomplished; however, I also believe that this form of investing does capture the essence of Intelligent Investing, the ability to find opportunity and minimize risk through the analysis of individual companies.
For that reason, I believe that Graham’s definitions of Defensive Investors and Enterprising Investors still stand, though the Defensive Investor of today is more of a hybrid of Graham’s versions, because the Defensive Investor does not seek the most passive investment tool but will still select some common stocks for his portfolio.
Defensive Investor Requirements
To be considered by the Defensive Investor, a company must pass at least 6 of the following 7 tests.
- Adequate Size of Enterprise – market capitalization of at least $2 billion
- Sufficiently Strong Financial Condition – current ratio greater than 2
- Earnings Stability – positive earnings per share for at least 10 straight years
- Dividend Record – has paid a dividend for at least 10 straight years
- Earnings Growth – earnings per share has increased by at least 1/3 over the last 10 years using 3 year averages at beginning and end of period
- Moderate PEmg ratio – PEmg is less than 20
- Moderate Price to Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50
Note: If the company is a financial or insurance company, test #2 regarding the financial condition is not required; however, the company must pass all six of the remaining tests.
Enterprising Investor Requirements
To be considered by the Enterprising Investor, a company must pass at least 4 of the following 5 tests or be suitable for the Defensive Investor.
- Sufficiently Strong Financial Condition, Part 1 – current ratio greater than 1.5
- Sufficiently Strong Financial Condition, Part 2 – Debt to Net Current Assets ratio less than 1.1
- Earnings Stability – positive earnings per share for at least 5 years
- Dividend Record – currently pays a dividend
- Earnings growth – EPSmg greater than 5 years ago
Note: If the company is a financial or insurance company, tests #1 and #2 regarding the financial condition are not required; however, the company must pass all three of the remaining tests.
Deciding on an Investor Type Strategy for Your Portfolio
Now that you know what each investor type is, and you know the requirements of each investment for the different investor types, you must decide which type you are. I am an Enterprising Investor, though I do not shy away from Defensive Investor opportunities when they arise, so I suppose some may argue that I am a blend of the two strategies. There is so much in common between the two, especially since companies suitable for Defensive Investors are by default also suitable for Enterprising Investors.
So what kind of Intelligent Investor are you? Are you a Defensive Investor or an Enterprising Investor?