Updated 4/21/2023

In the 14th chapter of Intelligent Investor, Benjamin Graham outlines his seven criteria for defensive investors. The Intelligent Investor, considered by many as the must-read book on investing, discusses value investing ideas.

Graham outlines his ideas regarding finding undervalued or out-of-favor stocks and buying them with a margin of safety in the book. These ideas remain central to value investing and have been embraced by many, including Warren Buffett, Mohnish Pabrai, and Howard Marks.

Two of Buffett’s favorite chapters remain Chapter 8 and Chapter 20, in which discussions of the margin of safety and Mr. Market occur. Both tenets continue today as central to Buffett’s success and other investors, including yours, truly.

Graham focuses much of his time on protecting your capital and not losing any money, thus the conversation concerning defensive investors.

In today’s post, we will learn:

• What is a Defensive Investor?
• Outline of Chapter 14: The Intelligent Investor
• Breakdown of the Seven Rules
• Investor Takeaway

Okay, let’s dive in and learn more about Chapter 14 and Ben Graham’s rules for a defensive investor.

What is a Defensive Investor

In his book, Graham describes investors as belonging to two camps:

• Defensive
• Enterprising

According to Graham, the defensive Investor is an investor who remains unable or unwilling to invest the time required for enterprising investments.

The difference between the two equals defensive investing as passive, whereas enterprising offers more active investing.

The defensive Investor focuses on building a portfolio that requires minimal effort, research, and oversight.

A defensive investor focuses on finding conservative investments that require little effort in portfolio management. Meaning they spend little time researching and selecting individual investments. The defensive investor typically doesn’t expand their universe beyond the limited conservative choices.

Most investors try to balance the risk they are willing to take against their risk tolerance. Graham looks at risk; differently; he feels that the amount of risk an investor should accept depends on the amount of effort the Investor is willing to exert or can exert.

Not everyone wants to or will spend the time necessary to build and maintain an active investment portfolio.

Defensive or passive investors must accept the return they track, which matches the market. Again nothing wrong with using the approach; it all comes down to your goals.

Greater returns are available for the enterprising investor, who wants and can spend more time assessing the markets.

The typical defensive investors carry a portfolio of 50/50% stocks and bonds, but Graham doesn’t mention age. One of Graham’s portfolio suggestion’s biggest takeaways is basing the blend on your risk tolerance, regardless of age.

That is contrary to most investment advice today, which suggests moving more defensively as you age.

Okay, now that we understand what a defensive investor is, let’s look at how Graham lays out the criteria for a defensive investor.

Outline of Chapter 14: The Intelligent Investor

In chapter 14 of The Intelligent Investor, Graham describes in detail how defensive investors should select stocks for their portfolio.

Graham refers to this as “broader applications of security analysis techniques.” Graham tells readers that following his suggestions will lead to choosing only high-grade bonds and a diversified group of stocks.

To create Graham’s list, he follows two approaches:

• A Dow Jones Industrial Average-type portfolio (DJIA)
• Quantitatively-tested portfolio

DJIA Portfolio

To create the DJIA portfolio, Graham suggested purchasing equal-weighting shares of the 30 companies comprising the Dow Jones.

Purchases of the entire exchange would offer diversification across a broad range of best industries and offer a little more stability than individual stock selection.

We can purchase either index, ETFs, or mutual funds to mimic the entire exchange’s purchase and achieve the same result in today’s age.

A simple, easy, and straightforward portfolio allows the defensive Investor to match the best 30 companies’ returns in the market without all the fuss of stock analysis.

Quantitatively Test Portfolio

Graham lays out his ideas in this portfolio when selecting individual stocks for the defensive Investor’s portfolio. While the industries he focuses on in the book are not as relevant today, i.e., railroads and utilities, the concepts still apply today.

Graham’s rules for stock selection are as follows:

1. Adequate size of the enterprise
2. Strong financial position
3. Stability of earnings
   • No earnings deficit in the last ten years
4. Dividend payer for 20 years
5. Earnings growth
   • At least 33% growth in earnings over the last ten years.
6. Conservative P/E ratio
7. Conservaive P/B ratio

We will cover the details of those individual criteria in just a moment.

Graham also elaborated on the idea of investing in the future either with a predictive or a protective approach.

• Prediction – investors or analysts will try to develop forecasts based on available information and predict what will happen based on that information. We can study trends, industry demand, volume, pricing, and costs, all of which attempt to forecast the future. Graham refers to this approach as the qualitative approach.
• Protection – investors look for a “margin of safety” to protect against the downside. Meaning they are looking for a company selling below its fair value. The protection method gives investors confidence in their picks without the euphoria. Graham calls this approach quantitative.

An example of these approaches would be assessing Microsoft’s revenue trend, service demand, and pricing advantages while spending less time on its price.

A quantitative approach would look squarely at the company’s value, determine if the company sells for less than fair value or on sale, and then buy if it is a good value.

At the end of the chapter, Graham states they were always committed to the quantitative approach, to no one’s surprise. Graham feels the defensive Investor should focus on diversification instead of individual stock selection.

Okay, let’s dive in and look at the seven rules a bit closer.

Breakdown of the Seven Rules

In this segment, let’s discuss each rule in more depth. In this selection process, Graham applied a group of standards to each grouping:

• A minimum of quality, as demonstrated by the company’s past performance and current financial position.
• A minimum of quality based on earnings history and price ratios.

Adequate size

In the 1973 edition of the Intelligent Investor, Graham argued for at least $100 million in sales for an industrial company. Which, by the way, were the dominant species in the markets, like tech is today. Or $50 million in revenues for utilities, also a big dog back in the day.

Today, most analysts suggest at least $2 billion in market cap as the minimum requirement.

Graham’s goal with the size requirement was to limit the volatility associated with smaller companies. Of course, we might have missed opportunities by playing in the larger market caps, but you avoid much of the up-and-down drama. Or even worse, the permanent loss of capital from bankruptcy.

Strong Financial Position

Graham felt that the companies should have:

• Current assets should be at least double current liabilities or a two-to-one current ratio.
• Long-term debt should not exceed working capital or net current assets.
• For utilities: the debt should be twice the stock’s equity or more.

Granted, Graham designed these ideas for industrials and utilities, but they still have validity. For example, search for companies with current assets twice their current liabilities and long-term debt less than working capital.

By doing a quick screen along those lines, we come up with the following:

• Snap-On Incorporated (SNA) – $9.03 billion market cap
• Oshkosh Corp (OSK) – $5.88 billion market cap
• UFP Industries – (UFPI) – $3.43 billion market cap

All three are attractive companies with conservative financing and in different industries.

Earnings Stability

Earnings stability remains an easy goal; Graham wants to see at least ten years of positive earnings, which equals no negative earnings over the last ten years.

Graham’s rule excludes companies IPOing with negative earnings or downturns for one year. It also excludes any young companies with only a few years of earnings, whether positive or negative.

With this idea, he is looking for more established types of businesses with long track records of positive earnings; it helps remove any younger or more fluid companies from their performance.

Dividends

As with earnings stability, we are looking for track record performance here. Graham looks for companies having twenty years, at least, of dividend payments.

For example, dividend aristocrats are a perfect example of the type of companies Graham would embrace. Dividend aristocrats have a record of paying a growing dividend for over 25 years, above Graham’s requirement.

Today, 66 companies are a member of the dividend aristocrats, and they range across the board in different industries:

• Coke
• Johnson & Johnson
• Federal Realty Trust
• Hormel
• Target

According to Kiplinger, 84% of all S&P 500 currently pay a dividend, which increases from 75% from a decade ago. Before the pandemic, there were increases in dividends from 169 companies.

The importance of dividends can’t be understated; in fact, over 42% of the returns of the S&P were from dividends over the period 1930 to 2019.

Earnings Growth

We are looking for 33% earnings growth per share over the last ten years, which Graham bases on three-year averages at the beginning and end.

If earnings grew 33% over ten years, that would work out to a 2.89% CAGR per year based on the math. At first, it sounds like a big number, but it is far more reasonable when we work out the percentages per year.

According to Jason Zweig, the Wall Street Journal journalist who contributed mightily to the latest edition of the Intelligent Investor with fantastic commentary. The average earnings growth from 1991 to 1993 and 2000 to 2002 was at least 33% higher.

Graham has set a low hurdle with the requirement, as the earnings growth has been less than 3% over a decade. Zweig suggests moving the earnings growth to 50%, which equals a 4% average annual rate. The idea helps widen the choice of investment choices while remaining conservative.

Moderate P/E Ratio

Graham wants an average P/E ratio of 15 over three years. We have many ways to calculate the P/E ratio; the most common method on Wall Street is using the forward P/E. They take the current price and divide it by the forward earnings or earnings estimates.

Instead, Graham suggests using the average of the last three years’ earnings dividend by the current price.

For example, let’s take a look at Walmart:

	Price	Earnings	P/E
FWD Earnings	$146.09	$5.58	26.18
Graham	$146.09	$3.59	40.69

As we can see from the above chart, there is a stark difference between the forward P/E and the historical P/E. As a defensive investor, looking at both P/E ratios to understand where the company has come from and where it is going is important.

Remember that most studies show that earnings “projections” miss their mark 59% of the time, so using an unknown number as the denominator makes zero sense.

Moderate Price-to-Book Ratio

Graham wants us to find companies with a current price no more than 1.5 times the last reported book value or a P/B ratio of 1.5 or less.

The price to book lessons in functionality as you search through different industries. For example, a software-based company like Microsoft is an asset-light company, whereas Chevron is far more asset-heavy.

Based on that idea, comparing the book values of those two companies makes little sense.

Consider the makeup of assets today; items such as goodwill, brand names, intangible assets, and patents make calculating tangible book value more difficult.

Another idea that Graham suggests is to take the current P/E ratio and multiply that by the company’s book value and see if it is less than the 22.5 he suggests. Graham uses this “blended multiplier” to screen for reasonably priced stocks.

Let’s look at a few examples to see this in action.

I am using Walmart from the above chart for the first example.

Walmart TTM P/E = 21.16

Walmart TTM P/B = 5.10

Graham Blended Multiply = 21.16 x 5.10 = 107.92

Let’s try that with a more conservative company such as Aflac (AFL)

Aflac TTM PE = 7.03

Aflac TTM P/B = 0.97

Aflace Blended Multiplier = 7.03 x 0.97 = 6.81

Pretty simple and a great way to screen for defensive companies. Remember, Graham focused on finding defensive companies investors could buy and hold without constant oversight.

Investor Takeaway

Ben Graham remains ahead of his time in many ways; he was one of the first to embrace security analysis and dig into the financials to find companies he felt had long-term prospects and sturdy financials.

He also embraced the idea of behavioral finance by understanding that not every Investor has the desire or time to investigate their investment choices. In his time, mutual funds and ETFs had little presence, so developing his defensive investors’ methods offered ground-breaking ideas.

Using the framework above is a great place to start investing, depending on your investment goals. Many of these tools work today, and depending on your risk tolerance, using some of the more conservative ideas might fit quite well in your portfolio.

Graham developed these seven criteria to suit defensive investors’ needs and temperaments, but some ideas translate well today.

Ideas such as looking for companies with strong balance sheets identified using a quick or current ratio metric is a time-tested approach. Companies with stronger balance sheets can withstand unexpected shocks such as the one the world recently experienced.

Another idea to embrace is the use of analyst estimates. Remember that they are only “estimates,” and because they come from knowledgeable analysts doesn’t mean they are right; as we saw, they are wrong almost two-thirds of the time!

Rather it is better to assess those earnings and ratios yourself and consider those numbers’ implications.

Using your judgment and intuition are great tools, and remember that no one knows the future and try to be rational at all times, even in the face of hysteria.

By the way, if you have not read the Intelligent Investor, run, don’t walk, and get this book and read it; a wealth of information will help you. Plus, Warren Buffett and Jason Zweig’s great commentary makes it doubly worth the money.

Today’s subject was defensive investors, but Graham does talk about enterprising investors, too; maybe that will be a topic soon.

With that, we will wrap up our discussion on Ben Graham’s thoughts on defensive investors.

As always, thank you for taking the time to read today’s post, and I hope you find something of value on your investing journey.

If I can further assist, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave