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!
ModernGraham’s Comments
Ben
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).
Heather
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.
Discussion Questions
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!
1. What quote from this chapter do you think best summarizes the point Graham is making? “We are not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand” It is significant to note that Dr. Graham has personalized this sentence, implying that what is described in this chapter is the methodology he prescribed to.
2. What do you think of Graham’s original requirements for Defensive Investors? They are sound advise and I always grade stocks for investment consideration using them as written.
3. Do you agree with the changes I’ve made for the ModernGraham approach? Not for my purposes. I still use sales volume (revenue) as a measure of company size because revenue is the life blood of any company. Secondly, I am not comfortable investing in companies with P/E much above 15 without substantial earnings growth demonstrated and forecast. I also tend to shy away from companies who’s book value (less goodwill) is not increasing along with its earnings.
4. Are there any other “modernizations” you would make to Graham’s requirements? I of course consider the effects of inflation regarding company size. Where in 1972 Graham recommended limiting purchases to companies with at least $100M in sales; in today’s dollars that would equate to $5.72M in sales or revenue. I don’t venture far away from his 22.5 limit for the product of the P/E ratio and P/B ratio, except that I exclude goodwill from the book value and allow for strong growth (or penalize for weak growth) by dividing the P/E ratio by the PEG ratio before multiplying by the P/B ratio. If you simplify earnings side of this equation you end up with a max P/E equal to growth or a PEG = 1. Undervalued stocks have a PEG <1 or a P/E 1 or a P/E>G. However I need to compute these values manually because I still use Graham’s 3 year earnings average and his 10 year computation for growth using 3 year average earnings on each end.
5. What did you think of the chapter overall? The best chapter in the book. It is a stand alone chapter that will keep an investor from making a multitude of poor investment decisions.
Requiring 6/7 of any of these requirements implies equal weighting. I would be curious to see a list of companies that pass ALL of the Modern Graham requirements with their valuations. Does such a summary exist on the Modern Graham site?
I would also be curious to see how restrictive the list would be if companies were required to pass all of the original Graham inflation adjusted requirements. I’m specifically referring to Dividend History and Price to Assets. Maybe Graham’s advice to Defensive investors would be to hold more conservative investment types as opposed to equities or excluding individual stocks entirely in today’s market.
Al – There are companies that pass all 7 defensive investor requirements, and they are posted on ModernGraham.com. Check out the drop down tab Explore Free -> Defensive Investor Screens -> then happy hunting.
1. What quote from this chapter do you think best summarizes the point Graham is making?
“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 ‘(margin of safety)’.
2. What do you think of Graham’s original requirements for Defensive Investors?
I like everything except his eliminatiing small companies.
Do you agree with the changes I’ve made for the ModernGraham approach?
I think $2 billion is too large a starting number. I like P/Es of <15X.
4. Are there any other “modernizations” you would make to Graham’s requirements? No I like the P/E of 15 and $100 million sales even today. Thar way small firms can be included.
5. What did you think of the chapter overall?
It's one of the great chapters of any investing book.
Ben, I cannot access chapter 15 nor have I received an email notification regarding its discussion. Did I somehow get a week ahead?
Richard
Richard,
I simply missed adding the link to the MG Book Club page. The post can always be found on Mondays on the ModernGraham.com front page.
I’m no longer having the book club post be the Subject line of the Monday emails, but the link can still be found in the email from that day. This week it was in the email with the subject line “General Electric June 2014 Quarterly Valuation $GE and more!”
Thanks for asking, and I hope that answers the question!
-Ben
1. What quote from this chapter do you think best summarizes the point Graham is making?
“His second choice would be to apply a set of standards to each purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price.”
2. 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?
I think Graham’s original requirements for the defensive investor look reasonable.
Adequate Size of the Enterprise: I would stick to annual sales as a measure of a company’s size. Graham used $100 million back in the beginning of the 1970′s, which equals about approximately $600 million today (calculated at http://www.usinflationcalculator.com/). So, I think that it seems appropriate to use a sales range of $600 million to $2 billion. Maybe for the defensive investor a sales range of $1-1,5 billion is suitable.
A Sufficiently Strong Financial Condition: Agree.
Earnings Stability: Agree.
Dividend Record: Agree.
Earnings Growth: 1/3 growth during the last ten years is a bit low I think. Maybe increase growth in earnings to 1/2 or 2/3.
Moderate Price/Earnings Ratio: I think an earnings multiplier of 15 is desirable, at least not above 20. An earnings multiplier between 15 to 20 times seems reasonable.
Moderate Ratio of Price to Assets: Agree.
3. Are there any other “modernizations” you would make to Graham’s requirements?
No, not at the moment. Maybe consider raising the growth in earnings to 1/2 or 2/3.
4. What did you think of the chapter overall?
One of the best so far.
1) What quote from this chapter do you think best summarizes the point Graham is making?
…Therefore, investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection – from overpaying for a stock and from overconfidence in the quality of their own judgment – is the best solution.
2) 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?
I think Graham made very fundamental criteria for the defensive investor. It certainly can use updating, and I am sure that is a main reason why he regularly put out new additions of this book. I think the ModernGraham approach is fine. It keeps the basics, and tries to update it. They key is using the same measuring stick for securities analysis. The only item that I might consider making a change to is not holding financial companies to the current ratio requirement. I understand that that requirement does not quite work for financial companies, but they often take on too much risk, and that should be quantified and measured to be able to make a good decision. I am not a fan of buying financial because of the fuzzy math they can use in their books.
3) Are there any other “modernizations” you would make to Graham’s requirements?
I think that there could be one quantitative and one qualitative measure added. On the quantitative side is possibly adding in a calculation for amount of cash and earnings available for minimum interest payments – Interest Coverage Ratio. Conservatively financed companies should have many times earnings available to cover interest expenses. This is a key problem if they do not earn more than interest due. The qualitative consideration has to do with how long management has been with the company. I like to see senior management has been with the company for multiple years; that shows me they are in it for the long pull.
4) What did you think of the chapter overall?
This is a great chapter. It sets they key criteria the defensive investor is to follow in clear easy to understand terms.
I’m wondering how you deal with a crash like 2008 – 2009 when calculating earnings stability. Obviously earnings/share dropped during that time (look at Deere & Co for example where 2008 = $4.70 and 2009 = $2.06). This means that it has a blemish on it’s record but that blemish is not necessarily something it is responsible for.
Do you take the slope of the EPS graph over that time and check to see if it’s positive?
I can see the general trend is upwards but mathematically, over 10 years, one year is not always greater than the next.
Thank you.
Kevin,
Thanks for the comment. Earnings stability is based on each year’s individual outcome, but the only requirement is that the earnings be positive. It does not require year over year growth, just that the company not lose money. After all, the number one rule in investing is to not lose money.