Intelligent Investor Ch.14 - Defensive Stock Selection

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Stock Selection for the Defensive Investor



The investment policies and concept of investing have been discussed in previous posts here:
and gives us the basic thinking behind the Stock Investment policy - in this post, we will go more in detail about the specific stock selection criteria!

Graham mentions two approaches

  1. Dow-Jones-Industrial-Average (DJIA) type portfolio
  2. Quantitatively tested portfolio

(1) In the first approach, DJIA type portfolio, you select all 30 companies in the Dow 30 and invest an equal amount into everyone, this would be your portfolio as of today!

An alternative is to select a low-cost index fund or an Exchange Traded Fund (ETF) that replicates the index as is.
Compare the cost of buying each individual stock with buying a fund or and ETF

A good example is the SPDR Dow Jones Industrial Average ETF which buys into the companies on the right side!

This is all you have to do - you are done!!!


This would have given you an annual return of ~10% (with dividends reinvested) or adjusted for inflation (CPI) a return of ~7.5% (with dividends reinvested)!


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(2) The second choice is to apply some set of standards to select a specific stock based on

  1. Minimum quality in past performance and current financial position of the company
  2. Minimum quantity in terms of earnings and assets per dollar of price
These seven qualities/quantities are presented us in the book for selection:

  1. Adequate Size of the Enterprise
  2. A Sufficiently Strong Financial Condition
  3. Earnings Stability
  4. Dividend Record
  5. Earnings Growth
  6. Moderate Price/Earnings Ratio
  7. Moderate Ratio of Price to Assets
1. Adequate Size of Enterprise The idea here is to exclude small companies that may be subject to more than average changes in price, even though these may be perfect for Enterprise Investors. The amounts used in the book are not less than $100 million of annual sales for an industrial company or not less than $50 million of total assets for a public company. In today, small caps are considered are companies with a market capitalization of less than $2 billion.

2. A Sufficiently Strong Financial Condition The current ratio, i.e. Current Assets should be at least twice Current Liabilities - a so-called two-to-one ratio! Also, long-term debt should not be higher than the Net Current Assets (or Working Capital).

3. Earnings Stability Taken directly from the book "Some earnings for the common stock in each of the past ten years".

4. Dividend Record Continous payment of a dividend for at least the last 20 years

5. Earnings Growth Here again we work with average, better three-year averages! A minimum 30% increase in earnings for the past ten years, compared in three-year averages!

6. Moderate Price/Earnings Ratio The current price should not be more than 15 times average earnings of the past three years.

7. Moderate Ratio of Price to Assets The current price should not be more than 1.5 times the book value.

A good idea is to add the last to ratios so that the P/E times the Price-to-Book should not exceed 22.5 (This is the same as a P/E of 15 multiplied by 1.5 times Price-to-Book, or P/E of 9 and 2.5 times asset value).

These standards are set-up for the character of a defensive investor! The standards are selected to exclude companies:

  1. that are too small
  2. that have a relatively weak financial condition
  3. that showed a deficit in the past 10 years
  4. that don't have a long history of continuous dividends
  5. that are not growing
  6. that are too "expensive"
Graham compares a company valuation based on P/E, or better the reverse P/E with AA bond yield. So a company with a P/E of 15 has a reverse P/E of 6.6% (1 divided by 15) - compared with the AA bond yield of 7.5%!

As the bond yield decreases, the P/E you can use increases! In 2003, the 10-year, AA-rated corporate yield was around 4.6%, which gives you a P/E of 22! 
We know, as of today, all the rates have been very low for the last years, and at the moment the AA-rated corporate bond yield is at around 2.5%, which would give you a maximum P/E of 40!!!

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When I set up a screen, I got two hits - one Industrial Company: Textron (Ticker:TXT) and one Consumer Cyclical Lennar (Ticker:LEN)!
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