Showing posts with label The Intelligent Investor: The Defensive Investor and Common Stocks. Show all posts
Showing posts with label The Intelligent Investor: The Defensive Investor and Common Stocks. Show all posts

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.

Thursday 2 July 2009

The Intelligent Investor: The Defensive Investor and Common Stocks

Chapter 5 - The Defensive Investor and Common Stocks
Graham’s advice, then, tends to focus on people who are willing to put in that extra time - and if you’re willing to do that, he has a lot of wisdom to share.

First of all, diversify. You should own at least ten different stocks, but more than thirty might be a mistake, as it becomes difficult to follow all of them carefully and also seek out new potential stock investments.

Second, invest in only large, prominent, and conservatively financed companies. Look for ones with little debt on the books and ones with a large market capitalization.

Third, invest only in companies with a long history of paying dividends. If a company rarely pays dividends, your only way to earn money from that company is if the market deems the stock to be valuable, and you shouldn’t trust that the market will do so.

Graham seems to point strongly towards the thirty stocks that make up the Dow Jones Industrial Average as a good place to start looking, as they usually match all of these criteria. I’d personally stretch that to include stocks that make up the S&P 500, but the Dow is a great place to find very large blue chip companies that are very stable and have paid dividends for a long time.

Other than that, Graham pooh-poohs many other common strategies.
Buying growth stocks? Nope.
Dollar-cost averaging? Good in theory, not great in practice.
Portfolio adjustments? Be very, very careful - and only do annual evaluations.

In short, be very, very wary and play it very, very cool.

Remember, this is Graham’s advice for the defensive, very conservative investor.


Commentary on Chapter 5
So, what does Jason Zweig have to say about all of this?

His big point is that simply “buying what you know” isn’t enough. You shouldn’t buy Starbucks’ stock simply because you drink their coffee. You need to spend the time to analyze the company’s situation, both internally and in the marketplace, and determine whether or not it’s a reasonable value. You can’t get there just by knowing the products they produce.

Zweig seems to generally feel that most people on the ground that are defensive investors are better off just buying mutual funds (preferably index funds) or seeking help from investment advisors, because the work needed to adequately study enough companies to build a good defensive portfolio is beyond what’s available to most people in their busy lives.

For me? I might tinker with individual stock buying, but I think I’d prefer to keep most of my money in index funds, simply because I, too, don’t feel like I have adequate time to really study enough stocks to build a good defensive stock portfolio.

Ref: The Intelligent Investor: The Defensive Investor and Common Stocks