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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