As mentioned in earlier chapters, Graham suggests that all portfolios, regardless of how aggressive or defensive the investor, must include both bonds and stocks. The major differences between defensive and aggressive investors is the proportion split between these two types of securities and the time spent maintaining the respective portfolios (aggressive investors must dedicate much more time, and in turn should achieve higher returns). This chapter discusses the stock portion of the defensive investor’s portfolio.
It deserves repeating to say that the reason common stocks are a necessary element of all portfolios is that they offer a considerable (though not perfect) degree of protection against inflation, whereas bonds offer no protection, and that common stocks have provided a higher average return (both appreciation of the security and dividend yield).
Graham provides four rules for defensive investors in selecting common stocks:
- Have adequate, though not excessive diversification. Generally 10 - 30 stocks.
- Each company should be large, prominent, and conservatively financed (Look for Debt-to-Equity ratio of 0.5 or less)
- Each company should have a long record of continuous dividend payments. (At least 10 years)
- The investor should impose a limit on the price he is willing to pay for an issue in relation to its average earnings. Graham suggests 25 times average earnings over the previous 7 years, or 20 times those of the previous 12 months.
In following these four rules, Graham suggests defensive investors use Dollar-Cost Averaging to purchase their shares over time. Dollar-Cost Averaging is the purchase of a set dollar figure of shares at regular intervals. So, if the share price goes up, you purchase fewer shares. Likewise, as the share price goes down, you purchase more shares. So the average price per share trends downward (since the lower prices are weighted more heavily by purchasing more of these shares). This eliminates the investor’s tendency to buy into the hype and purchase more shares as the price increases. Dollar-Cost Averaging maintains steady, patient investment.
A quote from the chapter on Dollar-Cost Averaging is: “no one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging”
A note on Growth Stocks
Graham uses part of the chapter to discuss growth stocks, which are those that have increased per-share earnings above the average growth for other common stocks. Graham cautions against investing in these with the familiar maxim “The hotter they are, the harder they fall.” He points to Texas Instruments and IBM to show how their strong growth led to the market pricing their shares at significant multiples of earnings, but once their earnings inevitably drop off, the market similarly overreacts to the lower earnings by reducing the share prices disproportionately. In other words, investment in growth stocks is risky and expect much greater volatility.
The Investor’s Personal Situation
Graham looks at three different personal situations (a successful doctor mid-career, a widow with dependents, and a young man starting his career). What is interesting from this section is that Graham once again goes back to his earlier discussion of risk and aggression and tells the reader that we must put away our preconceived notions of what portfolio policies these three different investors should adopt. The widow may very well have more time to devote to her portfolio than the doctor and as such she should invest more aggressively. The doctor, on the other hand, may have very little time to put toward his portfolio, so it would be more intelligent for him to not adopt risky policies.
I found this quite interesting because I had immediately reached knee-jerk conclusions as to what these three example investors should do. Everyone together now: how aggressive an investor should be depends on his willingness to put time and energy into his portfolio. Graham repeats this often.
Risk vs. Safety
Graham uses the end of the chapter to clarify the meaning and use of “risk.” Risk should NOT be used to refer to declines in the price of the security. Price fluctuation may be cyclical and temporary in nature. If the shares show a satisfactory overall return over a satisfactory time period, then it is safe - regardless of whether there are price fluctuations (because these can be expected).
Risk should only be used to refer to the likelihood of a significant deterioration in the company’s position.