Chapter 14: Stock Selection for the Defensive Investor

**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here

Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham takes us through what we should look for in stocks if we’re going to pick stocks and are of the Defensive Investor disposition. He reminds us that the defensive investor will only purchase high-grade bonds and a diversified list of leading common stocks. He will be sure that the prices of stocks when he buys are not unduly high as judged by applicable standards we have already discussed. Here’s the list of preceding posts if you’d like to get caught up:

• Intro and Chapter 1 , Chapter 2, Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, Chapter 9, Chapter 10, Chapter 11, Chapter 12, Chapter 13

Creating a diversified list

Right out of the gate, Graham wants to make sure that the investor is doing the appropriate amount of due dilligence to create a good, diversified list of which we can choose stocks. To create this list, Graham offers the following options: make it a DJIA-type portfolio, or apply a set of standards in an a la cart fashion.

DJIA List

In this case , the goal is to acquire a true cross-section sample of leading issues which will include some favored growth companies that will likely sell at high multipliers , but also includes some less popular, less expensive shares. Zweig adds, as we have already discussed, that the defensive investor could easily use a low-cost index fund that tracks the return of the total U.S. Stock Market.

A La Carte

In this case, the investor will apply a rigid set of standards to each a la cart purchase. These standards would look to make sure the investor obtains issues that adhere to the Seven Quality and Quantity Criteria that we began to describe previously.

The Seven Quality and Quantity Criteria

Below are what Graham feels we should consider when we’re choosing issues. All metrics and standards are in tune with what the defensive investor may want — we will address Stock Selection for the Enterprising Investor in Chapter 15

1. Adequate size

2. A sufficiently strong financial condition

3. Continued Dividends for at least 20 years

4. No earnings deficit in the past ten years

5. Ten-year growth of at least one-third in per-share earnings

6. Price of stock no more than 1.5 times net asset value (NAV)

7. Price no more than 15 times average earnings of the past three years

Adequate Size of Enterprise

The goal is to exclude small companies which may be subject to more than average vicissitudes (unpleasant circumstances) especially in the industrial field. While there are opportunities when investing in enterprises that don’t meet these size requirements, those opportunities do not meet the risk factors for defensive investors.

Logic:

• Firm should have less that $100M in annual sales for an industrial company
• No less than $50M in total assets for a public utility
• Zweig adds: Companies should also have a Total Market Value of greater than $2B

A Sufficiently Strong Financial Condition

Logic:

• For industrial , current assets should be at least twice current liabilities (two-to-one current ratio)
• Long term debt should not exceed net current assets (working capital)
• For public utilities : Debt should not exceed twice the stock equity (at book value)

Zweig adds: A defensive investor can always prosper by looking patiently and calmly through the wreckage of a bear market. Graham’s criterion of financial strength still works: If you build a diversified basket of stocks whose current assets are at least double their current liabilities, and whose long-term debt does not exceed working capital, you should end up with a group of conservatively financed companies with plenty of staying power.

Earnings Stability

Graham really wants us to be seeing at least some earnings for the common stock in each of the past ten years. Zweig follow’s up by affirming this test still works. In 2002 , 86% of all companies in the S&P matched our earnings consistency criteria.

Dividend Record

As with earning stability, we’re looking for a proven track record here. For the defensive investor Graham recommends uninterrupted dividend payments for at least the past 20 years. Zweig fills in : as of 2003 , 71% of the S&P had paid a dividend. No fewer than 255 companies have paid a dividend for at least 20 years in a row. 57 companies have raised their dividends at least 25 consecutive years.

Earnings Growth

A minimum increase of at least 1/3 in per share earnings in the past 10 years, using 3 year averages for beginning and end tails. Zweig adds that we are able to make a risk adjustment here. Considering the equation is to take average earnings of first three years, and the average earnings of the last three years in a ten year time frame. The average of the last 3 years should be at least 33% higher than the most historic three year tail. As Zweig notes, our risk adjustment can be in sorting companies for a higher growth rate, to something like 40, or 50% earnings growth over the span which would come out to a 4% and 5% growth per annum respectively.

Moderate P/E Ratio

The current price should not be more than 15 times average earnings of the past three years. Zweig states that for some reason, on Wall Street, it is common to find the value by dividing the stock’s current price by next year’s earnings (forward P/E ratio). Most often, these estimates are flat wrong and why would you want to guess on such an important datapoint. Instead, Calculate a stock’s P/E ratio yourself, using Graham’s formula: current price / avg earnings of the last 3 years.

Moderate Ratio of Price to Assets

Graham tells us to be looking for issues that have a current price not more than 1.5 times the book value last reported. If the issue were to have a multiplier of earnings below 15 , one could justify a correspondingly higher multiplier of assets. Graham’s rule-of-thumb : the product of the multiplier X ratio of price to book value ≤ 22.5 . Ex (15 x 1.5) = 22.5. One should remember that here we need to be sure that book value is calculated according to Graham’s method (eliminating Goodwill & Intangibles etc.)

Graham reminds us we’re looking at metrics designed for the defensive investor. The general premise that holds everything we’ve done together is that we are eliminating a lot of common stock issues that we don’t want by making sure we exclude companies that are:

• Too Small
• In relatively weak financial condition
• Have a deficit stigma in their ten-year record
• That don’t have a long history of continuous dividends

He reminds us that in certain markets, companies can really fall-short in our financial analysis where they used to be strong. We can see tell-tale signs if we see weakened current ratios or over-expanded debt. Moreover, by considering their ten-year record and continuous dividends we’re excluding many issues that might have adequate earnings and assets per dollar of price for enterprising investors — an indication of things to come. Instead, we hold an even higher standard and cut many companies and choose only ones with more earnings and more assets per dollar than the norm. Graham is helping force the investor to take a close look at how much the issue’s price is contingent on ever-increasing earnings. By keeping our perspective focused on rigid standards , we’re trying to strike the balance between issues depended too much on future earnings versus its assets and book value (as a value issue)… we’re building a margin of safety using the companies assets as collateral.

We hold a pretty rigid growth standard here to keep conservative, defensive approaches so we can cut out many firms that might otherwise not meet our profit per dollar of invested capital. Graham makes note however , that in some circumstances, we may find a company that doesn’t offer the strength in some areas presented above, but, that at a current price offer a bargain opportunity.

He adds:

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.

To expand with an example: If a 10-year AA-rated corporate bond yield was 4.6%, and we consider Graham’s formula that the stock portfolio should have an earnings-to-price ratio at least that high. We then take the inverse of that number (4.6 / 100) and find the “suggested maximum” P/E ratio of 21.7. Graham recommends the “average” stock price be about 20% below the “maximum” ratio. In this case that suggests stocks selling at no more than 17 times their three-year average earnings.

The Analysis Yield

As we look further at what having these types of standards yields, Graham gives us an example of what we might have seen during his time, if we held those standards:

We see here that only five companies met the requirements we set, and again we see that we can find all this information, or calculate this information from publications like the S&P Stock guide and other online stock aggregation tools. Considering the amount of money that might need to be spent on a subscription for a tool like that, consider that the money you pay, may be mere pennies compared to the principle you keep safe, and the gains you get based on the careful calculations with that data.

Utilities

Graham speaks further about investing in Utilities and how we, as investors, may need to modify our requirements. Back in Graham’s day, utilities were a much safer option and hadn’t experienced the volatility we’ve in the late ’90s. That is not to say investing in utilities is a bad thing, the point is that utilities are not as sure-fire as they were in Graham’s day. Zweig adds: there are currently better ways to own utilities , namely, through a low-cost index fund. Graham does not omit the test for the defensive investor when it comes to utilities: the ratio of current assets to current liabilities because the industry tends to handle its working capital through continuous financing by sales of bonds and shares. He continues however, with an emphasis on adequate stock capital to debt ratios as previously mentioned. He makes mention that public utilities do have the ability to be bought sometimes at low to moderate prices, when someone would buy into that company as an owner. What’s great is he elaborates a bit further by remarking that, like all other issues, the utilities can become a bit overvalued , therefore, we should be comfortable selling at our highs if we can use the highs as an opportunity to re-balance and find an issue of equal or undervaluation. Although we may pay capital gains tax, we might evade a high to low price drop, sell when high and free up capital for another bargain buy — not too shabby for the expense of capital gains tax.

Financial Enterprises and Railroads

Graham does offer some advice when it comes to working and investing in financial firms but his general advice centers back around keeping rigid standards of the same arithmetic of price in relation to earnings and book value as we had applied to industrial and public-utility investments. The one thing about financial firms we do need to be very cognizant of is handling their assets since most of them are intangibles in a sense that we have a lowered ability to sell, say a bundle of securities, as we may have with selling plant, property and equipment in a bankruptcy or solvency event.

Graham does give us general insights into railroad issues of his time. He gives example of Penn Central Transportation Co. He indicates that just before its bankruptcy , the company’s shares were selling at close to record highs and had paid a dividend, unbroken, for 20 years. Although we’ll look closer at the warning signs in Chapter 17, the point we want to highlight is that much of the company records and prices looked great, one should have looked “under the hood” as an owner to make his decision to buy it.

Selectivity for the Defensive Investor

Graham knows we’d like to choose the best possible stocks to incorporate into our portfolios, picks that retain our principal and grow. He offers that if analysts are all agreeing on one stock issue as the best, that the efficient markets hypothesis could then warrant that “value issue” no longer an issue of value. Therefore, we need to be setting in this case, defensive standards to adhere to, and then, meticulously research these companies and then, when the time comes to buy, to minimize trading costs and taxes.

Prediction versus Protection

Graham goes on to give some extremely cerebral advice. As we know, we don’t want to be buying in the hopes of future prospects , rather we want the knowledge of real value. Graham lays our two approaches that are often used, and emphasizes the pitfalls of any investment that focuses on the method of “prediction”.

The Predictive Approach, where future prospects, management and the human element (qualitative) are taken into account. This method has two boons: it is highly speculative, and it gives little to no regard for current price.

In contrast, The Protective Approach, being a quantitative and statistical approach emphasizes measurable relationships between selling price and earnings, assets, dividends, etc. Not only does the protective method protect our principal, it gives us a real understanding of the strengths and weaknesses of the enterprise that we may become owners of.

“We are not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand”

Why would we want to buy a lemon car because someone thinks it’ll be valuable in ten years, you could get stuck with it and find out it never returns!

“ our advice to the defensive investor is that he let it [choosing the best stocks] alone. Let him emphasize diversification more than individual selection. 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.

Zweig’s Commentary

As usual, Zweig’s comments are wise. We’ve touched on his points regarding choosing to invest in an all-market fund, but one thing I really liked was his advise for folks that still want to pick stocks. Instead of only picking stocks, keep say 90% of your money in an index fund, leaving 10% with which you can try picking your own stocks. If you’re successful, rebalance down to 10% and any remaining can go back into your anchor fund.

Most of Zweig’s commentary has already infiltrated the text above, however, he does finish on the note of due-dilligence. Even if you’re a defensive investor, you still need to do your research of the firms you wish to invest in. It is critical, a MUST. Using the EDGAR database, you can get all annual and quarterly filings. Furthermore, the proxies for the firms in EDGAR will give you details about manager compensation, ownership and potential conflicts of interest. Zweig advises we read at least 5 years of this data, surely you’ll be analyzing 7–10 years though. He also mentions taking a look at places like morningstar.com, yahoo finance, and the like to find what percentage of the issue is owned by institutions. his rule, anything over 60% means the stock is likely “over-owned”, exposing you to the risk of being at the whim of these institutional investors. Furthermore, he adds that websites like these will tell of the largest owners of the stock, you can then see if those owners fit the strategy you’re currently using. If all that lines up, you’re even better suited.

As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

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-David