The Intelligent Investor Series- Chapter 5 : The Defensive Investor and Common Stocks

Welcome back to the Intelligent Investor series. In chapter five of The Intelligent Investor we take a closer look at the administration of common stocks in the defensive investor’s portfolio. The chapter describes the benefits of common stocks; how a defensive investor should configure his portfolio. Here’s the list of preceding posts if you’d like to get caught up:

Graham starts by making a case as to why the defensive investor needs to continue focus on common stocks compared to bonds. He reminds the reader that stocks typically offer good protection against inflation compared to bonds and average a higher yield (in dividends) than bonds. I love how he focuses not on why you should buy stocks, but how you can lose these advantages if you pay too high a price for the issues of stock in the first place.

Taking dividends into consideration is equally as important. Zweig comments:

“A stock’s yield is the ratio of its cash dividend to the price of one share of common stock. If a company pays a $2 annual dividend when its stock price is $100 per share, its yield is 2%. But if the stock price doubles while the dividend stays constant, the dividend yield will drop to 1%.” — at the time he wrote this (2003), stock yields had never been higher than bond yield for four decades prior.

Defensive Parameters

In light of his affinity for stock issues, Graham offers the following parameters a defensive investor should follow when making stock acquisitions.

  1. Adequately diversify. Roughly 10 to 30 different issues
  2. Each company should be “ large, prominent, and conservatively financed”. “ An industrial company’s finances are not conservative unless the common stock (at book value) represents at least half of the total capitalization, including all bank debt” , “to be considered large a company should have a total stock value (or “market capitalization” of at least $10 billion (2003)”, the suggestion on company prominence is that the company is ranked among the first quarter or first third in size within its industry group”
  3. Company should have a long record of continuous dividend payments. Between 20 to 30 years of payments
  4. A suggested limit of a price not over 25 times average earnings, and not more than 20 times those of the last twelve-month period. The goal here being to eliminate “growth stocks” from the defensive investor’s portfolio.

Working into the portfolio itself, the defensive investor needs to ensure that his agents adhere strictly to the four rules and also have an understanding of the defensive investor’s goals to make few changes to his holdings or policies over the long term. Combined with a dollar-cost average buying plan of market-tracking index funds and the defensive investor’s portfolio has autopilot features baked right in. Graham does a good job noting that what matters isn’t your age but your required cashflows and ability to commit time to your investment education and administration of your funds.

On Risk

Graham later lays out an important perspective on the concept of risk. He mentions that the words “risk” and “safety” are applied to securities in two different senses which causes confusion. Graham says, a bond is considered unsafe when it defaults its interest or principal payments, just as a stock is considered unsafe if it misses a dividend payment the investor intended to capitalize on. Lastly, there is risk if there is a fair possibility that the holder may have to sell at a time when the price is well below the cost. However, he believes these types of risk are inherent in all other types of investments except U.S. savings bonds.

Graham believes the concept of risk needs to be applied solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration of the company’s position. More often, the cause may also be attributed to the overpayment for a security than its intrinsic worth.

Zweig’s noteworthy comments focus on concepts of what to buy, and how to buy it. He makes strong mention of “buying what you know”. That is, focusing your acquisitions in markets you’re familiar with, applying the four principles, and then analyzing their financial statements and business value. “Buying what your know” gives you the ability to buy issues with a lower educational overhead than, say, an industry that appears lucrative but would require double the time spent to research and determine the all-stars. He points out, however, that familiarity can breed complacency. Clinging to the singular hope that because you understand an industry means you needn’t investigate the business value is no acceptable way for a defensive investor to act. He cautions “ the more familiar a stock is, the more likely it is to turn a defensive investor into a lazy one who thinks there’s no need to do any homework.”

Lastly Zweig’s remarks about the benefits of dollar-cost averaging sheds light on one effective way of removing emotion from your investment strategies. With a DCA strategy and market tracking index funds, you’re able to answer “don’t know, don’t care” to anyone asking you to predict or speculate. Over time your gains should stack up and allow you to be relatively passive with your defensive investment strategies.

As I continue to work through the chapters, my goal is to post on each chapter’s central tenants. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.

Recommend the article if you found value in it and would like to follow along.



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