14. Stock Selection for the Defensive Investor
To reiterate:" a defensive investor is advised to purchase only high-grade bonds plus a diversified list of leading common stocks, purchased at a price that is not unduly high. In setting up his stock portfolio, he may either choose to arrange his portfolio to coordinate with an established market index or select a "quantitatively tested" portfolio.
Tracking a market index requires no analytical process: one simply acquires the same issues, in the same proportions, as the market index he wishes to track - for example, to track the DOW, the investor would buy ten shares of each of the thirty firms listed in the average - which at the time of this writing would be a cost of about $16,000, and adjust his holdings only when the index itself is adjusted to include or exclude specific issues.
(EN: The author does not mention mutual funds, but it seems to be that the management costs of a passive portfolio are rather modest - several options exist and fees are as low as 0.18%. I expect this would be less costly than commissions to buy, adjust, and reinvest dividends except when dealing with very large amounts.)
The second option, to select "quantitatively selected" issues, returns to the criteria the author previously described:
- Large: small companies are more subject to market fluctuations - they may represent good prospects, but at significant risk. The author suggests a firm that is among the largest players in its industry, considering annual sales and/or total assets.
- Financially Sound: at least a two-to-one ratio between current assets and current liabilities, and long-term debt should not exceed the net current assets of the firm
- Earnings Stability: No negative earnings per share in any of the past ten years.
- Dividend Stability: Uninterrupted dividend payments for the past 20 years.
- Earnings Growth. A minimum increase of at least 33% in per-share earnings in the past ten years, comparing three-year averages
- Moderate PE Ratio: A price to earnings that does not exceed 15, considering average earnings of the past three years
- Adequate Book Value: The current price should not be more than 1.5 times the book value of the firm.
These requirements are set up for the needs and temperament of the defensive investor, and will eliminate the majority of common stocks for rational criteria: they are too small, financially weak, unstable, or overpriced.
Some argument may be made over the last two criteria: a strong firm that is investing in expansion may suffer a higher PE ratio and lower book value to finance future growth. While this is reasonable, the defensive investor should consider the safety of an issue rather than its prospects for future growth, as the latter includes taking on risk that things will not go as hoped: the value of growth is already reflected in the fifth criterion.
Application to the DJIA
The author notes that the Dow index (as a whole) satisfied these criteria at the end of 1970, but two of them just barely.
If the criteria are applied to each individual company in the index, then only five of them meet all requirements.
Regarding the broader market of all firms, the author will "hazard the guess" that about 100 stocks could be found that would likely meet the criteria.
The Public Utility "Solution"
The editors note that Graham wrote favorably of public utilities at a time when they represented strong and stable investments, a situation that completely reversed itself due to the interference of regulatory agencies a few years after.
At the time, utilities were appealing to the defensive investor because, in terms of their size and stability, they met with the defensive investor's needs for large and stable firms that were not particularly glamorous, but steady and dependable earners with significant capital assets and income.
Investing in Stocks of Financial Enterprises
A myriad of different firms are included in the financial services sector: banks, insurance companies, savings and loan associations, mortgage firms, and investment companies.
The capital structure of this business is such that many of them have fewer traditional assets than manufacturing firms (plant, equipment, and inventory) and the cash and securities they manage are not the firms own property.
As such, they tend to appear to have great earning capabilities based on very few assets of their own, and the calculations performed to assess the performance of manufacturing firms are ill-suited to the financial services industry.
Ultimately, the author concedes that "we have no very helpful remarks to offer in this broad area of investment" except to counsel caution to the investor.
Railroad Issues
The railroad industry, which had been booming in the late nineteenth and early twentieth centuries, has since suffered much from a competition of severe competition and strict regulations.
Much of their passenger business has been lost to the automobile, bus, and airplane, and even their cargo revenues have been drawn to trucking. More than half the railroads in the country have been in bankruptcy in the past fifty years. And while they experienced some revival during the war years, they continue to be in decline.
The author notes that "it is usually unsound to make blanket recommendations of whole classes of securities," but in the case of railroads, the situation is so entirely terrible that the investor would do well to avoid the business entirely.
Selectivity for the Defensive Investor
The natural inclination of any investor, even a defensive one, is to earn as much return as possible on his investment, and the degree to which financial analysis has progressed in recent years gives undue credibility to the belief that by skill and insight, it would be possible to improve upon market returns, but this has never been consistently true.
The author supposes that if 100 professional analysts were asked to identify the five best stocks among the DJIA, they would not be identical: each would have different choices, for different reasons, and there would be no consensus among professionals. One can scarce find any other profession in which there is such fundamental and vehement disagreement when presented with the very same evidence to consider.
The very nature of the stock market depends on disagreements. If it were obvious to everyone that a given company would prosper, there would be unanimous interest in buying it and zero interest in selling it. Naturally, this would create a scarcity such that a few buyers would raise their offers to the point that a few sellers found them appealing, then a few other buyers would raise their offers further, and so on. This perfectly describes the activity that takes place on the trading floors.
The defensive investor's estimation of a "fair" price for a stock is based on fundamentally different assumptions and values than the estimation of a speculator, and each will pursue a course of action that reflects not only his estimates, but the rationale by which they choose to value a given security. In that sense, the two need one another to have someone to trade with, whose ideas are different from their own.
The fundamental struggle seems to be those who wish to avoid risk and earn a stable return, and those who wish to take on greater risk to earn a higher rate of return. To fall into the second category is to depart from investment and enter into speculation.
As such, the author's advice to the defensive investor is one opinion, with which he expects that certain of his readers will agree, and a great many others will disagree.