7 Tests of Defensive Stock Selection From Investor Benjamin Graham
Benjamin Graham's book, "Intelligent Investor", offers principles that 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 book "the greatest book on investing ever written." The unforgettable seven tests prescribed by Graham in Chapter 14, "Stock Selection for the Defensive Investor," 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.
Defensive Investing Tips From Benjamin Graham
An investor who 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 they are confident their analysis is both conservative and promises the safety of principal. Keep these seven tips in mind when putting your portfolio together.
- 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.
- Earnings stability for companies: The company should not have reported a loss over the past 10 years. Companies that can maintain at least some level of earnings are, on the whole, more stable.
- Dividend record of common stock: The company should have a history of paying dividends on its common stock for at least the past 20 years. This should provide some assurance that future dividends are likely to be paid.
- Earnings growth and profit of a company: 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 the course of the past 10 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 security.
- The 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 nine times earnings and 2.5 times asset value, etc.)".
More Information on "The Intelligent Investor"
Benjamin Graham's "Intelligent Investor" should be required reading 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.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.