Seven Tests of Defensive Stock Selection
Keys to Putting Together a Conservative Portfolio of Common Stocks
Each autumn, I read Benjamin Graham's Intelligent Investor. Its principles are timeless, unquestionably accurate, and contain a sound intellectual framework for investing that has been tested by decades of experience.
Even Warren Buffett considers Graham's Intelligent Investor "the greatest book on investing ever written." As I was considering what type of content to write for this article, I decided to focus on the unforgettable seven tests prescribed by Graham in Chapter 14, Stock Selection for the Defensive Investor.
Each of these will serve as a filter to weed out the speculative stocks from a conservative portfolio. Note that these guidelines only apply to passive investors seeking to put together a portfolio of solid companies for long-term appreciation
An investor that is capable of financial statement analysis, interpreting accounting decisions, and valuing an asset based on discounted cash flows may take exception to any of the following as long as he is confident his analysis is both conservative and promises safety of principal.
Adequate Size of the Enterprise
In the world of investing, there is some safety attributable to the size of an enterprise. A smaller company is generally subject to wider fluctuations in earnings while a large company is generally more stable by comparison. Graham recommended [in 1970] that an industrial company should have at least $100 million of annual sales, and a public utility company should have no less than $50 million in total assets.
Adjusted for inflation, the numbers would work out to approximately $465 million and $232 million respectively.
A Sufficiently Strong Financial Condition
According to Graham, a stock should have a current ratio of at least two. Long-term debt should not exceed working capital. For public utilities, the debt should not exceed twice the stock equity at book value.
This should act as a strong buffer against the possibility of bankruptcy or default.
The company should not have reported a loss over the past ten years. Companies that can maintain at least some level of earnings are, on the whole, more stable.
The company should have a history of paying dividends on its common stock for at least the past twenty years. This should provide some assurance that future dividends are likely to be paid. For more information on the dividend policy, read Determining Dividend Payout: When Should Companies Pay Dividends?.
To help ensure a company's profits keep pace with inflation, net income should have increased by one-third or greater on a per-share basis over course of the past ten years using three-year averages at the beginning and end.
Moderate Price to Earnings Ratio
For inclusion in a conservative portfolio, the current price of a stock should not exceed fifteen times its average earnings for the past three years. This acts as a safeguard against overpaying for a security. Learn more about the p/e ratio and how it can be used to value a stock.
Moderate Ratio of Price to Assets
Quoting Graham, "Current price should not be more than 1 1/2 times the book value last reported.
However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1 1/2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)"
More Information on The Intelligent Investor
Benjamin Graham's Intelligent Investor should be a required read for any investor. Within its pages are multitudes of facts and information that will provide you with an excellent foundation of investment knowledge and wisdom, and arm you with the necessary skills to unravel the complexities of investment valuation and analysis. For those of you who have yet to read Benjamin Graham's book, you can find more information and a book review of The Intelligent Investor in the top picks section.