My Key Takeaways From Chapter 5 and Commentary 5 of the Intelligent Investor. Part 6/16. To Be Continued.

Chapter 5 Defensive Investor and Common Stocks

Rules for the Common-Stock Component

The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would suggest 4 rules to be followed:

1. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
2. Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense clear. Observations on this point are added at the end of the chapter.
3. Each company should have a long record of continuous dividend payments. (All the issues in the Dow Jones Industrial Average met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.
4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past 7 years. We suggest that this limit be set 25 times such average earnings, and not more than 20 times those of the last 12-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. It would ban virtually the entire category of “growth stocks.”

Growth Stocks and the Defensive Investor

(Some authorities would say that a true growth stock should be expected at least to double its per-share earnings in ten years-i.e., to increase them at a compounded annual rate of over 7.1%.)

The problem lies there, of course, since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period.

In contrast we think that the group of large companies that are relatively unpopular, and therefore obtainable at reasonable earnings multipliers, offers a sound if unspectacular area of choice by the general public. We shall illustrate this idea in our chapter on portfolio selection.

Dollar-Cost Averaging

The NYSE has put considerable effort into popularizing its “monthly purchase plan,” under which an investor devotes the same dollar amount each month to buying one or more common stocks. This is an application of a special type of “formula investment” known as dollar-cost averaging.

Note on the Concept of “Risk”

It is conventional to speak of good bonds as less risky than good preferred stocks and of the latter as less risky than good common stocks.

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. Many common stocks do involve risks of such deterioration. But it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed “risky” merely because of the element of price fluctuation. But such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic value standards-even if any subsequent severe market decline may be recouped many years later.

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

To supply an element of concreteness here, let us suggest that to be “large” in present-day terms a company should have $50 million of assets or $50 million of business.

Commentary on Chapter 5

“Human felicity is produc’d not so much by great Pieces of good Fortune that seldom happen, as by little Advantages that occur every day.” – Benjamin Franklin

Amidst the bear market that began in 2000, it’s understandable if you feel burned-and if, in turn, that feeling makes you determined never to buy another stock again. As an old Turkish proverb says, “After you burn your mouth on hot milk, you blow on your yogurt.” Because the crash of 2000-2002 was so terrible, many investors now view stocks as scaldingly risky; but paradoxically, the very act of crashing has taken much of the risk out of the stock market.

Stocks are (as of early 2003) only mildly overpriced by historical standards. Meanwhile, at recent prices, bonds offer such low yields that an investor who buys them for supposed safety is like a smoker who thinks he can protect himself against lung cancer by smoking low-tar cigerattes.

In the 1980s and early 1990s, one of the most popular investing slogans was “buy what you know.” Peter Lynch-who from 1977 to 1990 piloted Fidelity Magellan to the best track record ever complied by a mutual fund-was the most charismatic preacher of this gospel. Lynch argued that amateur investors have an advantage that professional investors have forgotten how to use:” the power of common knowledge.”

Lynch’s rule-“You can outperform the experts if you use your edge by investing in companies or industries you already understand”-isn’t totally implausible, and thousands of investors have profited form it over the years. But Lynch’s rule can work only if you follow its corollary as well:” Finding the promising company is only the first step. The next step is doing the research.” To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.

Psychologists led Baruch Fischhoff of Carnegie Mellon University have documented a disturbing fact: becoming more familiar with a subject does not significantly reduce people’s tendency to exaggerate how much they actually know about it.

Through specialized online brokerages like www.sharebuilder.com, www.foliofn.com, and www.buyandhold.com, you can buy stocks automatically.

Some helpful online sources of information on buying stocks directly include www.dripcentral.com, www.netstockdirect.com (an affiliate of Sharebuilder), and www.stockpower.com.

Get some help. A defensive investor can also own stocks through a discount broker, a financial planner, or a full-service stockbroker.

Be warned, however, that buying stocks in tiny increments for years on end can set of big tax headaches.

The knowledge of how little you know about the future, coupled with the acceptance of your ignorance, is a defensive investor’s most powerful weapon.