5. The Defensive Investor and Common Stocks
In the original edition of this book, there was a long exposition on the case for including a substantial common-stock component in an investment portfolio. At that time, stocks were generally viewed as highly speculative and therefore unsafe, but much has changed over time, and most investors generally accept stock as a valid investment, even to the point where stock is the preferred vehicle of investments.
The chief advantage of stocks is also their chief source of risk: it represents a share of ownership in a commercial enterprise. As such, the holder of common stock shares in the profit of a company, but also shares in its risk. Stock prices therefore react more quickly to changes in an organization's profitability and the economic climate than do bonds, whose interest rate is locked at time of issuance (an individual bond does not change value, but bonds as a whole change in value over time).
To the defensive investor, stocks represent a hedge against increasing inflation - which his bond holdings remain fixed at a given rate, he may find the value of his holdings decreases when the rate of inflation exceeds his rate of return on his bonds. While issuers will happily redeem bonds when interest rates decline (and issue new bonds at a lower rate), they are not as interested in redeeming them when interest rates are on the rise (which would require refinancing debt at a higher rate).
Rules for the Common-Stock Component
The author sets four basic rules for a common stock portfolio:
- The portfolio should contain a minimum of ten stocks (the ensure diversification) but not more than thirty (to facilitate management)
- Each company should be "large, prominent, and conservatively financed."
- Each company should have a long record of continuous dividend payments over the previous twenty years
- The investor should set a maximum price he will pay on the basis of earnings: not more than 25 times average earnings over the past seven years, and no more than 20 times earnings of the last calendar year.
Growth Stocks and the Defensive Investor
The term "growth stock" denotes affirm which has increased its per-share earnings above the average rate for common stocks and is expected to do so in the future. Some suggest that a "true" growth stock should double its per-share earnings every ten years (growth of at least 7.2% annually).
The problem is that growth stocks tend to sell at high prices in relation to their current earnings, which prices them out of the portfolio given the rule of paying no more than 25x earnings, due to speculative activity. A few examples are given that illustrate the price of a stock can often advance five times as fast as its profits, and as such the price of such stock undergo periodic adjustment.
As such, growth stocks as a whole are attractive to the speculator, but too uncertain for the defensive investor. Meanwhile, large and stable companies, attractive to the investor, do not appeal to the speculator whose vision is more short-term.
Portfolio Changes
Nearly all brokerages provide the service to clients to review their portfolio and make recommendations for improving the quality of investments, and encourage clients to undergo such an evaluation at least once per year. This is done for no fee, but in hopes of earning commissions should the client choose to sell and purchase shares based on the brokerage's recommendations.
The motivation is clear: it is the hope of such brokerages to earn a steady stream of income by encouraging investors to steadily change their investments - and the investor, under the impression that the brokerage has greater expertise in the area of investment, will guide him to make better choices than he could for himself.
However, an investor who follows the four rules set forth in this chapter will find that he very seldom needs to make changes to his investment portfolio and, by maintaining this course, will save himself considerable losses from both performance fluctuations as well as brokerage commissions.
Dollar Cost Averaging
Considerable effort has also been put into popularizing the notion of a periodic purchase plan, by which an investor should devote the same dollar amount every month or every quarter to purchase into a position, that the investor can avoid the potential error of making a significant investment at "the wrong time."
One well-know study considered the effects of cost averaging in fairly numerous, overlapping ten-year periods, and concludes with the striking statement that this formula can be used with "confidence of ultimate success, regardless of what may happen to security prices."
While sound in principle, this is rather unrealistic in practice, as few people are so situated than they can have available for investment the same amount of money each month or quarter over the course of ten years. Neither has it been shown that this method is any more profitable than purchasing stocks at odd intervals in varying amounts, except in terms of the profit of the brokerage who, instead of receiving one commission for a single purchase in a given year, receives three or twelve commissions for regular small purchases.
The Investor's Personal Situation
The author contrasts the investment behavior of three sample individuals: a widow with $200,000 invested to provide support, a successful mid-career profession with $100,000 in current investments who wishes to make annual additions of $10,000, and a young man who earns $200 per week and saves $1,000 per year.
For the widow, the main concern is deriving sufficient income from her investments to cover her expenses, and she has considerable apprehension at the prospect of taking on any risk. Even so, she should be inclined to place some of her holdings in common stocks as a defense against inflation's tendency to erode the value of her investment, and arrive at a portfolio that is balanced between high-grade stocks and high-grade bonds.
It's noted that individuals living on a fixed income are often shuffled in the direction of the safest possible investment to preserve their level of income. The problem is that such individuals earn a fixed number of dollars, while inflation continues to erode the purchasing power of that amount, and as such find greater difficulty in meeting their expenses as tthey years pass.
The prosperous professional is not in a position to need a present income from his investment - but at the same time, he is not in a position to need to generate a significant return: his income being ample, there is no incentive to take on extraordinary risks. Moreover, as a professional, he has less time available to devote to researching investments and administrating his portfolio. As such, he would be better served by a conservative approach, similar to the widow.
It's noted that high-income professionals are "notoriously unsuccessful" in their security dealings. Since they have a high income, they are less concerned about risk, and because many of them are highly intelligent, they are overconfident in their decisions, even in subject areas for which their professional credentials leave them wholly unqualified.
The last example, of a young many who saves a little and expects to gradually improve his income over his lifetime, finds himself in a similar position: he has ample time for the seemingly-meager amount of interest earned by bonds to amass significantly over a longer period of time. And given that the total sum of his portfolio is likely to be small, it does not merit the investment of time.
It's noted that "finance has a fascination for many bright young people with limited means." Youth, by nature, is enterprising and entrepreneurial, as well it should be, and the young have ample time in life to recover from their early mistakes. But the author's perspective is that it's better to avoid making those mistakes, and developing expertise in sound and disciplined investment strategies rather than gambling on little knowledge.
Ultimately, the author's point is that a conservative approach to investing is well-suited to individuals in all stages of life and financial situations: it enables them to gain a reasonable return, avoid taking risks that would be financially damaging, and requires little knowledge or effort.
On the Concept of Risk
The concept of "risk" in investments tends to be somewhat blurred, and seems to imply both safety of principle and reliability of future returns. The two do not necessarily occur in equal measure.
The risk in investing in stocks is largely self-evident from the daily fluctuations in price - and while bonds are generally considered to be safe, they have been shown to be somewhat unreliable, when a company or a government entity finds itself with insufficient funds to make interest payments, or when a company is bankrupted and the liquidation of its assets is insufficient to repay its debt to its bondholders. There is no such thing as a completely safe investment.
Risk also applies to the decline in a price of a security, even if that decline is of a cyclical and temporary nature. Bonds also carry with them this risk, in that when the interest rates rise, older bonds that pay a lesser amount of interest cannot be redeemed for their full face value: the issuer has no interested in refinancing at a higher rate, and buyers in the open market are uninterested in buying a low-interest bond when a higher-interest one can be had for the same price.
Ultimately, an investor must take a long-range view of risk - specifically, taking the attitude that no loss has been incurred until his investments have been redeemed. A bond will always be worth its face value to an investor who holds it until the date on which it matures and, if he chooses carefully, he should have evaluated the risk of bankruptcy of the issuer prior to having purchased it - and his risk is no greater or lesser with the passage of time.
He can take the same attitude toward investments consider to be more risky, such as stocks. While the price of a stock fluctuates daily, the investor who plans to hold the stock for a long period of time need not be concerned with the daily up-or-down motion of the market. Over time, these vacillations will balance out and he should remain confident in his overall return.
In all, fear of risk in the market is like any other from of fear - it should not be permitted to cloud one's judgment, and it should have no place in sound decision-making.
On "Large, Prominent, and Conservatively Financed"
The quoted phrase was used earlier in this chapter regarding the stocks that should be held in an investment portfolio - and the author acknowledges "a criterion based on adjectives is always ambiguous" and ultimately meaningless. Any company is large when compared with those that are smaller, and the same follows for the other criteria - so a bit further explanation may be useful.
By "large," the author means that the firm is of substantial size, in terms of its book value, compared to others in its industry. In terms of its book value, it should rank in the top quarter of its industry group.
By "prominent," the author means that the firm should be among the leading firms in the industry, as demonstrated buy its gross revenue. Likewise, the firm should rank in the top quartile in terms of revenue.
These two notions are often coincidental. The third point, about fiscal conservatism, pertains to the degree to which the company is leveraged. That is to say, the common stockholders equity should represent at least half of the company's balance-sheet value (being equal to or greater than the total amount of liabilities).
These criteria area admittedly somewhat arbitrary, offered as rough estimates. The individual investor may set his own criteria to determine how large, prominent, and fiscally conservative he requires a firm to be prior to investing, and this will vary greatly by industry. For example, it would be reasonable to suggest consider a railroad or public utility to be "fiscally conservative" compared to its peers if its equity is about 30%.