Benjamin Graham, in the 14th chapter of the Intelligent Investor, outlines his seven criteria for defensive investors. The Intelligent Investor, considered by many to be 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 are central to value investing and have been embraced by many, including Warren Buffett, Mohnish Pabrai, and Howard Marks.
Two of Buffett’s favorite chapters are Chapter 8 and Chapter 20, in which discussions of the margin of safety and Mr. Market occur. Both of the tenets are 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:
According to Graham, the defensive investor is an investor who is unable or unwilling to put in the time required to be an enterprising investor. Think of the difference between the two as the defensive investor is passive, where the enterprising is more active.
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 available to them.
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 or is willing to spend the time necessary to build and maintain an active investment portfolio, and there is absolutely nothing wrong with that at all.
Defensive investors, or otherwise known as passive investors, must accept the return they track, which matches the market. Again nothing wrong with using that 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 your age.
That is contrary to most investment advice today, which suggests moving more defensive 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 the techniques of security analysis.” 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
To create the DJIA portfolio, Graham’s suggestion was to purchase equal weighting shares of the 30 companies that comprise the Dow Jones.
Purchases of the entire exchange would offer diversification across a broad range of industries that were the best 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:
- Adequate size of the enterprise
- Strong financial position
- Stability of earnings
- no earnings deficit in the last ten years
- Dividend payer for 20 years
- Earnings growth
- at least 33% growth in earnings over the last ten years.
- Conservative P/E ratio
- Conservative P/B ratio
We will cover the details on those individual criteria in just a moment.
Graham also elaborated on the idea of approaching investing in the future, either with a predictive approach or a protective approach.
- Prediction – investors or analysts will try to develop forecasts 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. Using this method enables investors to have confidence in their picks, without the euphoria. Graham calls this approach quantitative.
An example of these approaches would be assessing Microsoft’s trend in revenues, demand for its services, and pricing advantages while spending less time on its price.
A quantitative approach would look squarely at the company’s value, determine if it is selling for less than it is worth, or if it is on sale, and then buy if it were 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 that 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 a little greater 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.
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, there are missed opportunities by playing in the larger market caps, but you avoid many of the up and down drama. Or even worse, the permanent loss of capital from a 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 equity of the stock or more.
Granted, these criteria were designed for industrials and utilities, but they still have validity. For example, search for companies with current assets twice their current liabilities, long-term debt less than working capital. You will find some conservatively financed companies who will be around for some time.
By doing a quick screen along those lines, we come up with:
- 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.
The earnings stability is an easy goal; Graham wants to see at least ten years of positive earnings. That means no negative earnings over the last ten years.
Graham’s rule excludes any companies that IPO with negative earnings or companies with 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 to their performance.
As with earnings stability, we are looking for track record performance here. Graham looks for companies that have 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, but that is above Graham’s requirement.
Today, 66 companies are a member of the dividend aristocrats, and they range across the board in different industries:
- Johnson & Johnson
- Federal Realty Trust
According to Kiplinger, 84% of all S&P 500 currently pay a dividend, which increased 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.
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 10 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 when we work out the percentages per year, it is far more reasonable.
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 were at least 33% higher.
Graham has set a low hurdle with this requirement, as the earnings growth is less than 3% over a decade. Zweig suggests moving the earnings growth to 50%, which equals a 4% average annual rate. The idea being it helps widen the choice of investment choices while still being on the conservative side.
Moderate P/E Ratio
Graham wants an average P/E ratio of 15 over three years. There are many different ways to calculate the P/E ratio; on Wall Street, the most common method is using the forward P/E. Meaning they take the current price and divide that 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:
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, it is important to look at both P/E ratios to get a sense of where the company has come from and where it is going.
Keep in mind 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 lessens in functionality as you search through different industries. For example, a company such as Microsoft, a software-based entity, is an asset-light company, where 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 that Graham was looking for defensive companies that investors could buy and hold without much need of constant oversight on their part.
Ben Graham was 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 were few and far between, so developing his defensive investors’ methods was ground-breaking.
Depending on your investment goals, using the framework above is a great place to start investing. 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 temperament, but some ideas translate well to today.
Ideas such as looking for companies with strong balance sheets identified using a metric like the quick ratio or current ratio 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 think about those numbers’ implications.
Using your judgment and intuition are great tools, and remember that no one knows the future; 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; there is a wealth of information that will help you. Plus, the great commentary from Warren Buffett and Jason Zweig make it doubly worth the money.
Today’s subject was defensive investors, but Graham does talk about enterprising investors too.
With that, we will wrap up our discussion on Ben Graham’s thoughts on defensive investors.
As always, I want to 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 be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,