The Intelligent Investor: Stock Selection for the Defensive Investor

intelligentThis is the fifteenth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the fourteenth chapter, which is on pages 347 to 366, and the Jason Zweig commentary, on pages 367 to 375.

I’ve been writing these chapter-by-chapter discussions of The Intelligent Investor on my second read-through of the book.

The first time I read the book was roughly a year ago. To me, it came across quite like most good books – it built to a climax that contained the key portion of the book, which occurred about two-thirds of the way through. Prior to that climax was a ton of “setup” material – putting all the pieces in place so that the climax could be understood, processed, and enjoyed. The material after the climax was largely clarification and continuation – a bit more detail.

From my perspective, this chapter and the next (Stock Selection for the Enterprising Investor) serve as the climax of The Intelligent Investor. These chapters really outline what exactly Graham’s stock selection philosophy is in great detail.

This first chapter in the pair focuses on a more conservative philosophy for picking individual stocks, which personally appeals to me more than aggressive strategies. My personal philosophy for stock investing tends to stick pretty strongly to broad-based index funds – I have very little confidence that I can regularly pick stocks that will do substantially better than comparable index funds.

Chapter 14 – Stock Selection for the Defensive Investor
Graham’s strategy for defensive investors is actually pretty straightforward. He recommends that you start off with a broad index of funds – he uses the Dow Jones Industrial Average for his example, but the philosophy would work just as well with the S&P 500 or the Wilshire if you so wanted (and you could easily do that with computer-based tools).

Once you have this list, Graham suggests applying seven criteria to each stock on that list, in this order:

1. Adequate size of the enterprise Don’t invest in small companies, in other words. A defensive investor avoids stocks that would be considered small-cap.

2. A sufficiently strong financial condition The assets of any good defensive company should be at least twice the debts of that company.

3. Earnings stability The company must have had positive earnings each of the last ten years.

4. Dividend record The company must have made uninterrupted dividend payments each year for the past twenty years.

5. Earnings growth The company must have seen an increase of at least 33% in per-share earnings as compared to ten years ago.

6. Moderate price/earnings ratio The stock’s price must be nome more than 15 times the company’s earnings over the past three years.

7. Moderate ratio of price to assets The company shouldn’t have a stock value 50% greater than the total value of the company’s assets.

If you apply all of these criteria, even to every stock available, you’ll find the list of acceptable stocks at the end to be very, very small – if you find any at all. If you do find a stock that matches these criteria, it’s almost assuredly going to be a very steady value.

If you want to play around with these criteria using all publicly available stocks, it’s pretty easy to set up Yahoo’s Stock Screener. I used all of these criteria and didn’t find a single matching stock, but when I experimented a bit and loosened some of the criteria just a touch, I did find quite a few matches. This would be a great place to start for a defensive investor looking to jump into individual stocks.

Commentary on Chapter 14
Zweig’s message is simple: the easiest method for a defensive investor to invest in stocks today is by buying a broad-based index fund and simply sitting on it. This broad-based fund will match the stock market, have very little cost, and require very little effort from the buyer.

He does walk through each of Graham’s seven criteria for good defensive stocks and uses them to analyze the S&P 500 as it sat in early 2003 (when prices were pretty low). Zweig actually found that a sizable percentage of the S&P 500 passed each individual criteria, but he doesn’t mention how many companies pass all of the criteria – I’m willing to bet that it’s a very low number, if any at all.

Next Friday, we’ll take a look at Chapter 15: Stock Selection for the Enterprising Investor.

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  1. Curt says:

    These are great strategies under normal conditions, but we don’t have normal conditions. We have a massive decline in the entire economy. Stocks are going to continue to sell off until we get to the bottom of all the loses and the fed stops the bailout money. Then, we will be able to see when stocks are actually worth.

  2. Trent, I would really appreciate it if you went through exactly how you used the Yahoo stock screener and put these variables in. It’s a bit confusing when you first run it and are faced with a blank screen!

    -Erica

  3. The Personal Finance Playbook says:

    @ Curt. I disagree. Graham’s strategies are not tailored for normal conditions. If you read the book, “defensive strategies” are strategies that will withstand depression-like time periods. They are strategies that focus on capital preservation, even in extreme times.

  4. Saver Queen says:

    Zweig’s main point sounds a lot like the “couch potato” investing strategy encouraged by Money Sense Magazine.

  5. Dave says:

    Erica,
    “Adequate size” = market cap. Set the min to $1 or $10 bil
    “sufficiently strong financial condition” = debt:equity (you need to use the java screener for this)
    “earnings stability” = You have to do this on your own, but just write down the earnings in a spreadsheet for 10 years or whatever
    “dividend record” ditto
    earnings growth is an option. remember, 33% over 10 years is about 3% annualized (and screeners used annualized numbers)
    etc

  6. VC says:

    I agree with Curt, this is a severe recession and people have lost faith in stocks. Wall Street is shaken up. The job situation is only getting worse, unemployment is going to rise so the majority companies will not be increasing earnings anytime soon. Instead of picking stocks that are “defensive” and will not go down, pick stocks that play off of unemployment. One example is companies who do online colleges like Apollo Group or American Public Education Inc. These stocks have actually been growing because as people are losing their job, they are turning to online to colleges to improve their education.

  7. Fred says:

    An even simpler and lazier “strategy”:
    Call Madoff, wire him all your money.
    That’s it, you’re done; back to the sofa, you will never be bothered with this money again!

  8. jhl says:

    Warren B said, “Be greedy when others are wary, be wary when others are greedy.” More recently, he says to get into equities ASAP b/c it’s the least worst option in an inflationary environment.

    The government will continue printing money until the USD becomes so weak that the US worker can compete with China & India…

    Get ready to learn Mandarin & Hindi b/c we’ll be answering THEIR customer service calls soon.

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