"The Intelligent Investor" by Benjamin Graham: 5 - The Defensive Investor and Common Stocks

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Graham always makes the point that the higher the prices go, the higher are the risks involved. This Chapter refers to the stock market when the Dow hit an ATH of $381 during 1929. Following the crash, it took 25 years for the Dow to return back to its previous high. This should be of great consideration for the long-term investor. It is also important to note: during the peak of the market the dividend yields were lower than the bond market. This would cake it irrational to buy stocks since they “carry a greater risk” than bonds. Though many wall street “experts” said this relationship should be normalized within months, it took more than four decades for it to actually happen.

Graham’s guide to stock selection for the conservative investor*:

1. Adequate but not an excessive amount of diversification: 10 - 30 different investments
2. Every selected company should be large, with excessive and conservative financing**
3. A great history of dividend payouts
4. An average P/E of 25 times for the past 7 years of earnings and no more than 20 times for the past 12 months (this will take out all the speculative investments)

*These are all arbitrary assumptions and should be looked at as guides
** The book-value of the stock equals to at least half of its market capitalization, with at least $10 - $50 billion of Market Cap. It is prominent if it is the largest in its industry group

The hotter they are, the harder they fall:

A growth stock is an investment where its earnings are projected to double within ten years (7.1% compounded annually). The problem with these investments is that they are highly speculative, they usually don’t pay dividends, and as much as their prices rise, during recessions, their prices get decimated. Texas Instruments grew its earnings almost ten folds from $0.4 to $3.91 in six years while its price rose from $5 to $256. After an economic recession and proof that the earnings growth was coming to a halt, its value dropped to $49. It is worth advising that growth stocks are not suitable for the defensive investor.

Dollar-Cost Averaging

Dollar-cost averaging refers to the method of accumulating securities with the same lump-sum amount every x period of time. Graham says this method could be unrealistic for people to stick to over a 20 year period of time, however the results could be very impressive for the savers. According to Ibbotson Associates, If one invested $12,000 on September 1929 in S&P 500 their investment would have shrunk to $7,240 in 10 years. But if they had invested $100 every month for the same time, they would have amassed $15,600. The best advice given here is to invest monthly in mutual funds with portions dedicated to different areas (for example ⅗ into us stocks, ⅕ into bonds, and ⅕ into foreign stocks).

General Advice:

As someone new to investing, do not try to beat the market. Your goal must not be the rate of return (ROI) on your investments based on your financial recourses, but of your ROI based on your financial equipment such as knowledge, experience, and temperament. Owning investments today does not depend on your historical performance. You must always do your homework before you pick investments. You should never invest in a company without studying its financial statements.

Some say only invest in the things you know, like the company you work for, but as you can recall the employees of Enron did not know of the great scandal that was going on. Also just because you research about something doesn’t mean you know it and can make good investment decisions towards it. This can only grow your bias towards it and force you to make the wrong decisions. Always remember:

A defensive investor runs - and wins - the race by sitting still

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