Tuesday, 26 March 2013

Benjamin Graham's Intelligent Investor - What stocks to buy for the Defensive Investor

The Defensive Investor and Common Stock
Common Stocks offer protection against inflation and provide a better than average return to investors. 
This higher return results from a combination of the dividend yield and the reinvestment of earnings (undistributed profits), which increases value. 
However, these benefits are lost when the investor pays too high a price. 
One should recall that prices did not recover again to their 1929 highs for another 25 years. 
However, the defensive investor can not do without a common stock component.
4 Rules for the Defensive Investor Accumulating Common Stock
4 Rules for the Defensive Investor Accumulating Common Stock:
1.      There should be adequate, although not excessive, diversification; that is, between 10 and thirty stocks.
2.      Each stock should be large, prominent, and conservatively financed.  Conservatively financed means a debt to capital ratio no greater than 30%.  Large and prominent means that the firm, in 1972 dollars, has at least $50 million in assets and annual sales, and it should at least in the top third of its industry group.  Each of the 30 DJIA firms met this criteria in 1972.
3.      Each firm should have a long record of continuous dividend payments.
4.      Each stock should cost no more than 25 times the average of the last 7 years of earnings, and no more than 20 times the last 12 months earnings.

This last rule virtually bans all growth and other “in-favor” stocks. 
Due to the fact that these issues sell at high price, they necessarily possess a speculative element. 
A “growth stock” should at least double its earnings per share every 10 years for a minimum compounded rate of return of 7.1%. 
The best of the growth stocks, IBM, lost 50% of its value during the declines of 1961 and 1962. 
Texas Instruments went from $5 to $256 (a 50x increase) in six years without a dividend payment as its earnings rose from $0.40 to $3.94 (a 10x increase); 2 years later TI’s earnings fell 50% while its stock price fell 80% to $50.
The temptations here are great, as growth stocks chosen at the correct prices provide enormous results. 
However boring, large firms that are unpopular will invariably perform better for the defensive investor.
Dollar Cost Averaging (“DCA”) often is popular during rising markets. 
If DCA is adhered to over many years, then this formula should work. 
The difficulty is that few people are so situated that they can invest the same amount each year. 
Economic downturns often constrain one’s ability to invest just when stocks are trading at their lowest valuations. 
Furthermore, when prosperity for the average investor returns, so too do high valuations.
Most people fall into the “defensive investor” category. 
Graham provides examples such as a widow who cannot afford unnecessary risks, a physician who cannot devote the time for proper analysis, and a young man whose small investment will not return enough gain to justify the extra effort.  
The beginning investor should not try to beat the market
The beginning investor should not try to beat the market.
The investor only realizes a loss in value through the sale of the asset or the significant deterioration of the firm’s underlying value
Careful selection and diversification helps to avoid these risks. 
A more common and difficult problem is overpaying for securities; that is, paying more for a security than its intrinsic value warrants.

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