The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
Defensive investors have two possible strategies for stock selection:
Buy the Market - Acquire a cross-section sample of the leading issues. This will include both high-priced popular and low-priced unpopular companies. This can be done easily today by buying a low-cost index fund, like those offered by Vanguard.
Zweig describes index funds as “the best tool ever created for low-maintenance stock investing - and any effort to improve on it takes more work (and incurs more risk and higher costs) than a truly defensive investor can justify.” I’ll write more about index funds when I review The Little Book of Common Sense Investing by John Bogle.
Select Individual Stocks with a minimum quality of past performance and financial position. In selecting these stocks, the defensive investor must follow the seven criteria set out in an earlier chapter:
- Adequate Size (Today, this means at least $2 billion in market value)
- Sufficiently strong financial condition (at least 2:1 current ratio)
- Earnings stability (10 years of consistent earnings)
- Dividend Record (uninterrupted payments for 20 years)
- Earnings Growth (Minimum of at least 1/3 increase in per-share earnings in the past 10 years using three year averages at the beginning and end)
- Moderate Price/Earnings Ratio (No more than 15x)
- Moderate Ratio of Price to Assets (Current price not more than 1.5 x book value)
Once you have found stocks that meet all of these criteria, it is time to do your homework and look through their annual and quarterly reports, and proxy statements. Also, check out what % of the company’s shares are owned by institutions. Zweig says that anything over 60% sugests the stock is “overowned” (when the institutions sell, they tend to do so in lockstep, killing the share price).
By following the above rules, the defensive investor creates an adequate factor of safety upon which he can rest.
It is at this point that Graham makes a point that must be understood to grasp this book: You must recognize that, while you invest in the present, you invest for the future, and in so doing, there are only two methods of considering the future: prediction or protection. To claim you can predict anything relevant about the future with any accuracy and be able to consistently make money off this is foolish, so forget about it. Instead, you must invest for the future by protecting yourself in the present.
By protecting yourself in the present, you strive to create a substantial margin between what you pay for the stock and what you think it is worth (after careful analysis) so that this margin can absorb the unfavourable and unpredictable developments in the future.
In short, defensive investors are best to diversify rather than select stocks individually. If they are going to select stocks individually, they must do so carefully with a mind toward building as great a margin of safety as possible so as to protect themselves in the future.