In the 14th chapter of “The Intelligent Investor,” Benjamin Graham drills deeper to discuss how defensive investors can or should select stocks; in chapter 15 he will do the same for enterprising investors.
He refers to this as the “broader applications of the techniques of security analysis.” Graham promises those who follow his suggestions will buy only high-grade bonds and a diversified group of leading stocks.
To create this list of stocks, defensive investors will take one of two approaches:
- A Dow Jones Industrial Average-type of portfolio.
- A “quantitatively-test-portfolio.”
The DJIA-type portfolio would have been created by buying the same number of shares in each of the 30 stocks that comprised it. Now, we would simply buy an index mutual fund or exchange-traded fund, but those were not so commonly available when Graham published the final edition of his book in 1973. Graham refers to investment funds, but it is helpful to recall the first real index fund was introduced by John Bogle in 1975. In buying all companies in the Dow Jones, investors would get a cross-section and some diversification.
Graham‘s analysis from this point forward is based on the prominent categories of his time, but the lessons he teaches in each of these categories continue to be relevant.
Assessing industrial stocks
Turning to the “quantitatively-test-portfolio,” Graham says this would apply a group of standards to each purchase:
- A “minimum of quality,” as demonstrated by past performance and a company’s current financial position.
- A “minimum of quantity,” based on earnings and assets per dollar of price.
These are his quality and quantity criteria:
- Adequate size: In 1973 he was arguing for at least $100 million in annual sales for an industrial company (which dominated the markets in his day; tech stocks were still more than a decade away), or $50 million in total assets for a public utility (public utilities were also popular in Graham’s time).
- “Sufficiently strong financial condition”: For industrial companies, current assets should be at least twice current liability. In addition, long-term debt should not be greater than net current assets or working capital.
- Earnings stability: Companies must have an earnings history of at least 10 years.
- Dividend record: At least 20 years of uninterrupted payments.
- Earnings growth: An increase of at least 33% in earnings per share in the past 10 years, based on three-year averages at the beginning and the end.
- Moderate price-earnings ratio: The price-earnings ratio should not exceed 15 times average earnings of the previous three years.
- Moderate ratio of price-to-assets: Do not pay more than one-and-a-half times the most-recently reported book value. Still, Graham is willing to be somewhat flexible, noting that a multiplier of earnings below 15 could justify a higher multiplier of assets. Further, “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 1.5 times book value.)
Note, all these figures are available to members of GuruFocus, in the dashboards of individual companies.
These seven criteria, says Graham, are designed to suit the needs and temperament of defensive investors. Note he gives needs and temperament apparently equal weights; he was ahead of his time in giving serious weight to what we now call behavioral finance.
From a functional perspective, they help defensive investors avoid companies that are too small, in a relatively weak financial position, have a record of deficits in the past 10 years or do not have a sufficiently long record of continuous dividends.
Looking specifically at the last two criteria—moderate price-earnings and moderate price-to-assets— Graham says he is at odds with many analysts by demanding more earnings and more assets per dollar of price.
“This is by no means the standard viewpoint of financial analysts; in fact most will insist that even conservative investors should be prepared to pay generous prices for stocks of the choice companies. We have expounded our contrary view above; it rests largely on the absence of an adequate factor of safety when too large a portion of the price must depend on ever-increasing earnings in the future.” (author’s emphasis).
Public utilities
To be clear, those were the criteria for evaluating industrial companies. When considering public utilities, he excludes the criterion of current assets to current liabilities (the current ratio), but sticks with the other six. There is a distinct benefit to public utility stocks:
“For the defensive investor the central appeal of the public-utility stocks at this time should be their availability at a moderate price in relation to book value. This means that he can ignore stockmarket considerations, if he wishes, and consider himself primarily as a part owner of well-established and well-earning businesses.”
Graham adds that while investors can consider themselves part owners of businesses, the market is always there to seize on opportunities. Those opportunities allow investors to buy shares, or more shares, when prices are low, or to sell when prices go too high.
Stocks of financial enterprises and railroads
Graham covers these areas relatively quickly, but his remarks show pithy insight that remains relevant today:
- On financial stocks: a relatively small part of their assets are material things, so “The question of financial soundness is, therefore, more relevant here than in the case of the typical manufacturing or commercial enterprise.”
- On railroads: The 1973 edition of the book came out shortly after the bankruptcy of Penn Central Transportation Co. (“our most important railroad”) and reflected the pessimism surrounding railroad stocks at the time. Graham says, “Let us confine our suggestion to this: There is no compelling reason for the investor to own railroad shares; before he buys any he should make sure that he is getting so much value for his money that it would be unreasonable to look for something else instead.”
How to approach the future
Graham notes there are two different ways of dealing with the future: (1) a predictive or projection approach and (2) the way of protection:
- Prediction: analysts who prefer prediction will try to develop a reasonably accurate forecast of a company’s future fortunes. They study such issues as industry-wide supply, demand, volume, price and costs. Alternatively, they may project a “rather naïve” line from past growth. Graham calls this a qualitative approach.
- Protection: These analysts demand a “substantial” margin of safety, meaning the current market price must be significantly below the stock’s present value. This gives investors confidence without having to be enthusiastic about the company’s long-term prospects. They simply need to be reasonably confident that the company will “get along”. This is a quantitative approach.
As the chapter ends, Graham says, “In our own attitude and professional work we were always committed to the quantitative approach.”
And, “Thus this matter of choosing the 'best' stocks is at bottom a highly controversial one. Our advice to the defensive investor is that he let it alone. Let him emphasize diversification more than individual selection.”
Conclusion
One theme keeps appearing over and over in this chapter: always base your decisions on the difference between present value and the market price. If current prices are well below present value, there is a margin of safety and investors have a good reason to buy (assuming all else is satisfactory). On the other hand, if there is no margin of safety, or an inadequate margin, stay away from the company, no matter how appealing its prospects.
Investors are also urged to choose quantitative approaches over qualitative. In other words, don’t buy based on intuition, rosy predictions or forecasts of any kind. Instead, stick to analyses, with hard numbers from past performance and prices.
Finally, Benjamin Graham worked in a world of industrials, public utilities, railroads and so on. Today, the field looks much different thanks to technology, globalization and other transformative practices. Nevertheless, Graham’s core ideas are still relevant and still effective.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)
