Most people idolise Warren Buffet for his phenomenal investing triumphs, and rightly so. But do you know who his mentor was? It was Benjamin Graham, an American analyst and an ace investor, credited as the father of value investing and security analysis. His strategies and ideas can be explored in his two most popular books, ‘Security Analysis’ and ‘The Intelligent Investor’. While they are considered a must-read for any newbie, it can be difficult to understand and grasp the concepts right away.
In this article, we will predominantly look at Benjamin Graham’s investment strategy for defensive investors and the seven criteria listed for them, which are discussed at length in his book ‘The Intelligent Investor’.
Who is a defensive investor?
To understand Benjamin Graham’s 7 stock criteria, you first have to understand who qualifies as a defensive investor in the share market. As per Graham’s examination, investors who refuse to put enough time and effort into their investments are known as defensive or passive investors. Simply put, they are not inclined to invest proactively and prefer a portfolio that requires the least possible supervision and research. Therefore, conservative investments appeal to them the most as they demand basic contemplation.
You must have often heard investment experts doling out the advice of opting for investments as per your risk appetite. However, Graham suggested that investors should adopt risk that is in line with the level of intelligent effort they are prepared to spend.
Such passive investors can cultivate balanced investment portfolios by investing in debt and equity. Graham proposes that defensive investors, if they are willing, should consider dividing their wealth equally, i.e., 50% in bonds or cash and 50% in stocks. These portfolios can be readjusted when the value of the assets on either side rises by 10% or more. For example, if the portfolio composition stands at 60% equity and 40% bonds, a conservative investor can sell 10% of their equity and purchase bonds to maintain parity.
Graham’s 7 stock criteria for defensive investors
To simplify the process of picking stocks, Graham has outlined seven stock criteria for defensive investors. If you identify as a passive investor, these guidelines can be extremely helpful in deciding which stocks are appropriate for your portfolio.
- Company size: Graham mentions that passive investors should steer clear of engaging with small company stocks, as they are vulnerable to volatility. According to him, larger businesses are steadier in terms of earnings. Likewise, the market sentiment is usually positive about well-established companies. Plus, large-cap companies are not expected to spring any balance sheet surprises on you. Since they are stable and are unlikely to over or underperform, they make for a feasible option for defensive investors.
- Respectable current ratio: A current ratio is employed to measure a company’s short-term liquidity and is calculated by taking into account its existing assets and liabilities. In other words, it gauges the ability of a company to produce sufficient revenue to clear its debts and is typically utilised to deduce its overall fiscal health.
A healthy current ratio differs from industry to industry. Often, a ratio between 1.5 and 3 is acceptable. However, you should also pay attention to the sector average before settling on a decision. Be mindful of companies that have a ratio less than 1, as it often indicates cash flow problems. Similarly, companies with ratios exceeding 3 could signal that they are struggling to optimally handle their working capital and assets. Overall, a healthy current ratio is a sign that the company has a diminished risk of bankruptcy, making them a more secure choice for defensive investors. - Steady gains: In Graham’s view, for a stock to be worthy of investment, it should exhibit recurrent positive gains over time. He urged conservative investors to check the revenue made by a company in the last 10 years and evaluate if it has demonstrated profitability and consistency in the long run.
- Past dividend payments: Most defensive investors lean towards stocks that pay dividends, proving the presence of a regular income. Hence, before investing, they should check the history of a company’s dividend payments. Graham believed that investors should strongly consider companies that have been periodically paying solid dividends for a minimum of 20 years.
- Earnings growth: Though Graham was sceptical about anyone who claimed to precisely anticipate a company’s earnings growth, he desired to invest in businesses that have steadily amplified their profits. This hints at the fact that the company is prospering. He advocated defensive investors should target companies that have recorded a rise of at least 33% in earnings per share in the past decade, computed using the three-year averages at the start and the end.
- P/E ratio: In conjunction with other factors, investors are encouraged to look at the price-to-earnings (P/E) ratios of companies. Graham asserted that conservative investors must seek investments where the current market price does not exceed the average earnings more than 15 times in the last three years. Please note that the P/E ratios vary by industries and sectors. Similarly, double-check P/E ratios of the competing companies to make an informed call.
- Price to asset ratio: The usage of price to asset ratio is uncommon these days. This is because there is a surge in technology-based businesses, and this ratio is largely put into practice for assessing companies from the traditional sectors, such as consumer goods, energy, and manufacturing, which are capital-oriented. However, if you do employ it, Graham recommended that the current market price of the stock should not surpass the last reported book value more than 11.5 times. However, if the P/E ratio of the company is lower than 15, it might have an elevated price-to-asset ratio.
Additional read: Price-to-book ratio
Closing thoughts
Benjamin Graham’s 7 stock criteria can be a useful starting point for beginners who want their investment portfolio to grow without constantly changing their strategy. Applying Benjamin Graham’s criteria is not a foolproof way to build a lucrative portfolio, especially for investors or traders who are risk-friendly. However, it can still help solidify your research and enable you to pick safer stocks while excluding those irrelevant in the long haul.
