Here’s How A Defensive Investor Should Think About Stocks

April 26, 2018

Here’s How A Defensive Investor Should Think About Stocks

We all like common stocks, but in this stage of the economic cycle we should also be defensive. Therefore, it’s a perfect time to discuss Chapter 5 of Benjamin Graham’s book The Intelligent Investor – The Defensive Investor and Common Stocks.



The topics we’ll discuss today are:

  • Four rules to follow when buying stocks.
  • Growth stocks.
  • Dollar cost averaging.
  • Investor’s personal situation.

The Defensive Investor & Common Stocks

In this chapter, Graham discusses how in 1949, stocks were considered highly speculative but by the end of the 1960s, stocks were considered a must have.

The situation isn’t much different now. Stocks are considered the best investment out there while in 1982, stocks were considered risky, highly speculative, and not something to own. This is typical for how humans go about stocks. Don’t forget that in your lifetime there will be at least two such market cycles. The main point is that stocks are sometimes extremely cheap and sometimes they are extremely expensive and the key is to properly allocate your portfolio funds in relation to the risk and reward.

So, yes, stocks have and will probably deliver inflation protection and higher returns over the long term, but these benefits, to quote Graham, “could be lost by the stock buyer if he pays too high a price for his shares.”

This was the case from 1929 when it took 25 years for stocks to regain lost territory, and let’s hope it won’t be another historical case for 2018 even though valuations and debt look similar. Of course, reinvesting dividends changes things, but now there isn’t much to reinvest.

Graham had no enthusiasm for common stocks in late 1971 due to the high valuations.

Figure 1: S&P 500 PE ratio in 1971. Source: Multpl.

It’s important to note that in 1971, the yield on the 10-year Treasury was above 6% which made stocks even more expensive. Now the yield is 2.87% which makes stocks look better, but still definitely not cheap especially if yields continue to go up.

Figure 2: 10-year Treasury yield. Source: FRED.

Inflation in 1971 was at 5%, so the situation for bonds was similar to the current one where yields are around 2% and inflation is as well. Therefore, if we have the same approach as Graham, we should have no enthusiasm for stocks in 2018. But let’s dig deeper as Graham never advocated a stock-free portfolio.

As stocks could be the lesser of two evils, bonds being the other evil now with rising interest rates and inflation, Graham gives us 4 rules to follow when investing in stocks:

  1. Adequate but not excessive diversification – minimum of 10 and a max of 30 stocks.
  2. Buy only large, prominent companies with low debt risk (not more than 50% debt, leading industry position, and have a larger than $20 billion market cap).
  3. Each company should have a long record of continuous dividend payments (at least 20 years).
  4. Put a limit to the price you are willing to pay in relation to the earnings average over the past 7 years where the limit is 25 the average earnings and 20 for the current year earnings.

All seems sound with Graham’s rules, but these guidelines will allow you to buy good companies of one which—Kraft Heinz—we are going to discuss this Sunday. But the above criteria would exclude the hot growth stocks everyone is crazy about now. Let’s see Graham’s take on growth stocks.

Growth Stocks & The Defensive Investor

Graham is against owning growth stocks when it comes to defensive investors because he thinks that they are for the non-professional. It’s easier to find money on trees than to pick the right growth stock. Let’s quickly put Amazon into perspective.

Figure 3: AMZN’s stock price over the last 5 years. Source: CNN Money.



Graham simply sees too much risk in such stocks because it’s absolutely possible for such a stock to grow another 500% in the next 5 years, but it’s also possible to see it fall greatly if the growth slows down and earnings contract. Graham uses the example of IBM and Texas Instruments, both growth stocks in the 1960s that fell 50% twice and 80%, respectively.

The main message is the hotter growth stocks become, the harder they fall. Graham prefers the relatively unpopular stocks with reasonable valuations.

Portfolio Changes For The Defensive Investor

If an investor selects stocks based on Graham’s 4 rules and avoids hot growth stocks, there should be no need for many changes in one’s portfolio. But as the defensive investor doesn’t have the expertise to shuffle around, Graham suggest finding expert advice, but then again, that’s even trickier than to do it yourself.

Dollar Cost Averaging

Graham touches on dollar cost averaging where you invest an equal amount each month for 20 years. He finds it to be a great strategy, but discusses the difficulty of sticking to it over time as things in life change. More about dollar cost averaging here.

Investor’s Personal Situation

I’m a firm believer that one’s personal situation and smart personal finance decisions are way more important than picking the best stocks, and Graham has put forth three excellent examples to discuss this:

  1. A widow with a million dollars and 7 children to support,
  2. A mid-career doctor with half a million in savings, and a
  3. Young man earning $1,000 per week and saving $5,000 a year.

The prescription for the widow is clear. Conservativeness with an allocation to both bonds and high quality stocks. He goes for the 75% to 25% separation depending on the level stocks are at at the moment, thus the answer would be 25% stocks and 75% bonds in 2018. The main message for the widow is not to take any kind of risks.

As for the doctor, Graham thinks the same as if the doctor doesn’t seriously approach the business of investing, there isn’t much they can do. However, Graham says that medical professionals shouldn’t invest by themselves because they don’t have the time to learn what’s going on, or they should remain defensive.

On the young man, Graham has the same advice as given the inexperience, quality bonds will save him from lots of things. However, it’s also good to gain experience with small, insignificant sums.



The Concept Of Risk

Graham describes how there is a big difference between the concept of risk and safety when investing.

Just as back then, today risk is understood as the chance for a stock to go below its current price, but that isn’t risk for Graham. Risk for Graham is more personal where you are forced to sell at a lower cost than what you paid. However, if the business has been doing well in the past and will continue to do so in the future, we can’t call a stock risky.

Conclusion

If you don’t have much time to be an aggressive investor, Graham provides everlasting tips to make investing easy.

People forget that a return of just 7.2% per year will see you double your money every 10 years which means that $100,000 invested today would end up at $1.6 million after 40 years. Enough for a cosy retirement.

See how this laid back approach of mixing bonds and stocks fits your lifestyle and investing goals.



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