Benjamin Graham

Chapter 5 – The Defensive Investor and Common Stocks

Summary and Discussion – Chapter 5 – The Defensive Investor and Common Stocks
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created November 21st, 2013
Last updated December 3rd, 2013
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • There are intrinsic benefits to common-stock ownership, relative to alternative asset classes such as bonds. However, these benefits can be sacrificed if the buyer pays too much for her shares.
  • Dollar-cost averaging can help defray the risk of overpaying for shares.
  • Investors’ styles should differ depending on their life situation.

Graham begins this chapter by acknowledging, and then cautioning against, the argument in favour of common stock ownership which he advanced in the 1949 edition of The Intelligent Investor. This argument rests on two premises (emphasis added):

1) That common stocks “had offered a considerable degree of protection against the erosion of the investor’s dollar caused by inflation, whereas bonds offered no protection at all.” [1]

2) That common stocks offer “higher average return to investors over the years,” a phenomenon “produced both by an average dividend income exceeding the yield on good bonds and an underlying tendency for market value to increase over the years in consequence of the reinvestment of undistributed profits.” [2]

To this Graham offers the following caution: “While these two advantages have been of major importance—and have given common stocks a far better record than bonds over the long-term past—we have consistently warned that these benefits could be lost by the stock buyer if he pays too high a price for his shares.

Note Graham’s consistent lack of categorical recommendations. A given investment (be it a bond, common stock, or otherwise) makes sense if and only if (and because) the conditions are right. Of these “conditions”, the price paid for the security is—if not foremost—then certainly high on the list.

An important note on the relationship between dividend stock prices and dividend yields. A stock’s “dividend yield” is the percentage of the stock price which is paid out to stockholders as cash. Therefore, a company whose stock costs $10 and whose dividend is $0.20 per share has a dividend yield of 2%. Because of this, it follows that an increase in the price of the stock causes the dividend yield to decline, and vice-versa.

An important note on the manner in which dividend yields should be interpreted. Companies’ dividends should be interpreted principally in relation to two considerations:

  1. How does this dividend yield compare to the yield offered by high-quality bonds?
  2. How secure is this company’s dividend relative to the yield offered by said bonds?

In the past, stock dividends would nearly always be higher than high-quality bonds yields based on the premise that companies—as a general rule—are more likely to default on their obligations than are the issuers of high-quality bonds. This rule, however, is not always the case: At the time of Graham’s writing (in the early 1970s), bond yields were generally higher than the dividend yields on common stocks. Therefore the investor must ask herself whether current dividend yields are sufficient compensation for the generally increased risk of stocks relative to high-quality bonds; there is a general tendency to overlook bonds as being genuinely competing candidates for investment viz. stocks. This tendency should be resisted in order for valuable opportunities not to be missed.

Rules for the Common-Stock Component

  1. “There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.” [3]
  2. “Each company selected should be large, prominent, and conservatively financed.” [4] Graham elaborates on these points at the end of the chapter.
  3. “Each company should have a long record of continuous dividend payments.” [5]  By “long record”, Graham posits a minimum of 20 years’ uninterrupted dividend payments. Note that this rule has three components:
    1. That the company must issue a dividend.
    2. That the dividend must have been issued for at least 20 years.
    3. That the dividend must have been continuous (never interrupted) for each of those (minimum) 20 years.
  4. The investor should not overpay in relation to the company’s average earnings over the past 7 years. Graham suggests that “this limit be set at 25 times… average earnings, and not more than 20 times those of the last twelve-month period.” Graham readily acknowledges that this last rule “would ban virtually the entire category of “growth stocks,” which have for some years past been the favourites of both speculators and institutional investors.” [6] The justification for this exclusion will be elaborated presently. [7] To summarize the above:
    1. Price paid must be less or equal to 25 times the average earnings over the preceding 7 years.
    2. Price paid must be less or equal to 20 times the average earnings over the preceding 12 months.

Growth Stocks and the Defensive Investor

What is a growth stock? “The term “growth stock” [refers to a company] which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future.” [8]

Is there anything categorically wrong with investing in growth stocks? No. The only concern is that growth stocks are notoriously difficult to buy at a good price. “Obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive.” [9] That last part’s the clincher.

So then, why include rule #4 (above) if it almost necessarily forbids the purchase of growth stocks? “The problem lies there, of course [re: above, “provided the price paid is not excessive”], since growth stocks have long sold at high pricesin relation to current earnings and at much higher multiplesof their average profits over a past period. This has introduced a speculative element of considerable weight… and has made successful operations in this field a far from simple matter.” [10] Graham’s critique boils down to three core concerns:

1) Growth stocks are almost always overpriced in relation to their current earnings and past profits.

2) Growth stocks attract speculation which causes the stock to become even more overpriced (and therefore even less attractive from a value investing perspective).

3) This volatility is conducive to rapid and chaotic crashes in the price of the stock, which have a devastating long-term effect on the profitability of the investment. [11]

“The reader will understand… why we regard growth stocks as a whole as too uncertain and risky a vehicle for the defensive investor. Of course, wonders can be accomplished with the right individual selections, bought at the right levels, and later sold after a huge rise and before the probable decline. But the average investor can no more expect to accomplish this than to find money growing on trees. In contrast we think that the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, [12] offers a sound if unspectacular area of choice by the general public. We shall illustrate this idea in our chapter on portfolio selection.” [13]

Portfolio Changes [14]

Graham comments on the pros and cons of attending annual consultations through which to receive feedback on one’s investment portfolio. On the “pro” side lies the fact that most investors lack expertise; on the “con” side lies the fact that many consulting firms are no better than most investors (and, moreover, charge fees and/or commissions for their services). My own recommendation is to rely on oneself, provided that one is confident in one’s ability to adhere to the principles of value investing articulated in The Intelligent Investor. In the absence of this confidence, one should commit to educating oneself before making any investments.

Graham notes, though, that if one’s portfolio has been “competently selected in the first instance, there should be no need for frequent or numerous changes.” [15]

Dollar-Cost Averaging [16]

The phrase “dollar-cost averaging” refers to the practice of investing a pre-determined sum of money (say, $100) routinely at a pre-determined length of time (say, once per month) in a pre-determined company or set of companies (say, Microsoft or the Nasdaq exchange). The logic behind dollar-cost averaging is that it prevents the investor from investing the bulk of her money at an unusually high price; instead, she is bound to invest her money both at high prices and at low prices, assuming she follows the routine of dollar-cost averaging diligently. Put in practice, such a formula would involve making the monthly investment irrespective of market conditions; whether before, during, or after a crash, for example.

Graham notes that this method, if genuinely followed, does indeed offer a convenient and straightforward way for the investor to guard herself from the all-too-human impulse of buying high and selling low. He notes, though, that such monthly purchases should be complementary to (rather than exclusive of) similar monthly purchases in bonds. [17]

The Investor’s Personal Situation

“To what extent should the type of [investments made] by the investor vary with his circumstances?” [18] To explore this question, Graham posits three hypothetical investors: [19]

  1. “… [A] widow left $200,000 with which to support herself and her children;”
    1. Graham’s recommendation: “conservatism in her investments in paramount”, posits 50-50 split between “United States bonds and first-grade common stocks”.
  2. “… [A] successful doctor in mid-career, with savings of $100,000 and yearly accretions of $10,000;”
    1. Graham’s recommendation: same as above, notes that “medical men have been notoriously unsuccessful in their security dealings,” [20] because “they usually have an ample confidence in their own intelligence and a strong desire to make a good return on their money, without the realization that to do so requires both considerable attention to the matter and something of a professional approach to security values.”
  3. “… [A] young man earning $200 per week and saving $1,000 a year.” [21]
    1. Graham’s recommendation: “The balance is so modest that it seems hardly worthwhile for him to undergo a tough educational and temperamental discipline in order to qualify as an aggressive investor. Thus a simple resort to our standard program for the defensive investor would be at once the easiest and the most logical policy.” I disagree slightly with Graham: my own view is that all investors should undergo “tough educational and temperamental discipline”, especially young investors with a lifetime of investment potential in front of them. Having said this, I agree entirely with Graham that the defensive approach is nonetheless preferable in this instance. The additional education would merely prepare the young investor to recognize and responsibly act upon meaningful opportunities as they present themselves throughout his or her life.

Note the almost complete uniformity of Graham’s recommendations: conditions under which non-defensive investment practices are preferable over their defensive alternative are rare indeed, irrespective of the age or income of the investor.

In summation, Graham notes that “the kind of securities to be purchased and the rate of return to be sought depend not on the investor’s financial resources but on his financial equipment in terms of knowledge, experience, and temperament.” Of these three, I posit that temperament is by far the most valuable.

Note on the Concept of “Risk” [22]

Graham distinguishes between the notion of risk as it ought to be understood by the intelligent investor, and risk as it is in fact understood by most market participants.

Risk as it ought to be understood Risk as it is commonly (mis)understood
True: “A bond is proved unsafe when it defaults its interest or principal payments.” False: An investment is proved unsafe if its price declines, “even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times.”
True A company is proved unsafe if it fails to pay its stock’s declared dividend.
True: A company is proved unsafe if it reduces its stock’s dividend in a manner contrary to the reasonable expectations of its investors.
True: “[A]n investment contains a risk if there is a fair possibility that the holder may have to sell at a time when the price is well below cost.”

“This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.” [23]

Note on the Category of “Large, Prominent, and Conservatively Financed Corporations”

Earlier in the chapter, Graham noted that only “large, prominent, and conservatively financed corporations” are suitable for defensive investment, and noted that he would elaborate on the precise meaning of this phrasing at the end of the chapter. [24] This elaboration is here outlined.

  • “Conservative”: “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. For a railroad or public utility the figure should be at least 30%.” [25]
  • Large” and “Prominent”: “The words “large” and “prominent” carry the notion of substantial size combined with a leading position in the industry.” [26]
    • “[L]et us suggest that to be large “large” in present-day terms a company should have $50 million of assets or do $50 million of business… [T]o be “prominent” a company should rank among the first quarter or first third in size within its industry group.”

A note on these definitions: “It would be foolish… to insist upon such arbitrary criteria. They are offered merely as guides to those who may ask for guidance. But any rule which the investor may set for himself and which does no violence to the common-sense meanings of “large” and “prominent” should be acceptable.” [27]

Footnotes
[1] 113.
[2] 113.
[3] 114.
[4] 114.
[5] 115.
[6] The term “institutional investors” refers to market participants such as pension funds, investment banks, and hedge funds. It is in contrast to the term “retail investors”, which refers to individuals. This principles of value investing apply equally to institutional and retail investors.
[7] 115.
[8] 115.
[9] 115.
[10] 116.
[11] Graham doesn’t say this directly, but the reason behind this concern is arithmetical in nature. Consider a scenario in which you invest $10,000 in a company (via its stock), after which the stock price declines by 50%. Under these conditions, the “market value” (meaning, the amount of money you would receive–on average–from other market participants in the event you should chose to sell all of your shares) of your investment would be cut exactly in half, to $5,000. The key question is, What percentage gain in the price of your investment would be required in order for it to return to a market value of $10,000? On face value, it might be tempting to think that the answer is 50%. However, this is not the case. A 50% rise in the price of your investment, applied to $5,000, yields only $7,500 ($5,000 + 0.5 * $5,000). In fact, a 100% rise would be required in order to regain the initial $10,000 market value of your investment ($5,000 + 1 * $5,000). This simple fact of arithmetic is sometimes referred to as “the mathematics of losses”. It is an important fact to remember, and a powerful argument in favour of defensive investing.
[12] What Graham means by “earnings multipliers” are generally referred to today as “price-to-earnings ratios”, or “P/E ratios” for short.
[13] 116-117.
[14] 117.
[15] 117.
[16] 118.
[17] Graham also cites life insurance as a way of making the point that dollar-cost averaging, if seriously implemented, must be incorporated into one’s monthly expenses and carried out routinely and consistently, with exceptions kept to an absolute minimum. Preferably, no such exceptions would ever be made.
[18] 119.
[19] These figures need to be adjusted for inflation; they here reflect the value of the U.S. dollar c. 1972, and are therefore inaccurate at time of reading.
[20] The term “security dealings” is interchangeable with the term “investments”; the word “security” denotes a financial instrument such as a stock or a bond.
[21] 119.
[22] 121.
[23] 122.
[24] 114.
[25] 122.
[26] As with the salary and savings figures quoted previously, these figures need to be adjusted for inflation; they here reflect the value of the U.S. dollar c. 1972, and are therefore inaccurate at time of reading.
[27] 123.

Advertisements