Chapter 14.

Stock Selection for the Defensive Investor

The defensive investor who follows our suggestions will purchase only high-grade bonds plus a
diversified list of leading common stocks. In setting up this diversified list he has a choice of two
approaches, the DJIA-type of portfolio and the quantitatively- tested portfolio. In the first he acquires
a true cross-section sample of the leading issues, which will include both some favored growth
companies, whose shares sell at especially high multipliers, and also less popular and less expensive
enterprises. This could be done, most simply perhaps, by buying the same amounts of all thirty of the
issues in the Dow-Jones Industrial Average (DJIA).

His second choice would be to apply a set of standards to each purchase, to make sure that he obtains
(1) a minimum of quality in the past performance and current financial position of the company, and
also (2) a minimum of quantity in terms of earnings and assets per dollar of price.

7 quality and quantity criteria’s

Adequate Size of the Enterprise

Our idea is to exclude small companies which may be subject to more than average vicissitudes
especially in the industrial field. Let us use round amounts: not less than $100 million of annual sales
for an industrial company and, not less than $50 million of total assets for a public utility.

A Sufficiently Strong Financial Condition

For industrial companies current assets should be at least twice current liabilities. Also, long- term
debt should not exceed the net current assets. For public utilities the debt should not exceed twice the
stock equity.

Earnings Stability
Some earnings for the common stock in each of the past ten years.

Dividend Record
Uninterrupted payments for at least the past 20 years.

Earnings Growth
A minimum increase of at least one-third in per-share earnings in the past ten years using three-year
averages at the beginning and end.
Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past three years.

Moderate Ratio of Price to Assets

Current price should not be more than 11⁄2 times the book value last reported. However, a multiplier
of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb
we suggest that the product of the multiplier times the ratio of price to book value should not exceed
22.5.

Comments
These requirements are set up especially for the needs of defensive investors. They will eliminate the
great majority of common stocks in two opposite ways. On the one hand they will exclude companies
that are (1) too small, (2) in relatively weak financial condition, (3) with a deficit stigma in their ten-
year record, and (4) not having a long history of continuous dividends. Our last two criteria are
exclusive in the opposite direction, by demanding more earnings and more assets per dollar of price
than the popular issues will supply.

Application of Our Criteria to the DJIA at the End of 1970

All of our suggested criteria were satisfied by the DJIA issues at the end of 1970, but two of them just
barely.

1. Size is more than ample for each company.

2. Financial condition is adequate in the aggregate, but not for every company.
3. Some dividend has been paid by every company since at least 1940. Five of the dividend
records go back to the last century.
4. The aggregate earnings have been quite stable in the past decade. None of the companies
reported a deficit during the prosperous period 1961–69, but Chrysler showed a small deficit
in 1970.
5. The total growth was 77%, or about 6% per year. But five of the firms did not grow by one-
third.
6. The ratio of year-end price to three-year average earnings was 839 to $55.5 or 15 to 1—right
at our suggested upper limit.
7. The ratio of price to net asset value was 839 to 562—also just within our suggested limit of
11⁄2 to 1.
If, however, we wish to apply the same seven criteria to each individual company, we would find that
only five of them would meet all our requirements. The result is that there are very few industrial
companies that meet all the criteria. It is therefore difficult to make a satisfactory personal choice
within the range.

The Public-Utility “Solution”

If we turn now to the field of public-utility stocks we find a much more comfortable and inviting
situation for the investor. Here the vast majority of issues appear to be cut out, by their performance
record and their price ratios, in accordance with the defensive investor’s needs as we judge them. One
criteria was excluded - the ratio of current assets to current liabilities. The defensive investor could
have had quite a wide choice of utility common stocks, each of which would have met our
requirements for both performance and price. In comparison with prominent industrial companies as
represented by the DJIA, they offered almost as good a record of past growth, plus smaller
fluctuations in the annual figures also the dividend return was significantly higher. The position of the
utilities as regulated monopolies is assuredly more of an advantage than a disadvantage for the
conservative investor.

For the defensive investor the central appeal of the public-utility stocks at this time should be their
availability at a moderate price in relation to book value. This means that he can ignore stockmar- ket
considerations, if he wishes, and consider himself primarily as a part owner of well-established and
well-earning businesses

Investing in Stocks of Financial Enterprises

A considerable variety of concerns may be ranged under the rubric of “financial companies.” These
would include banks, insurance companies, savings and loan associations, credit and small-loan
companies, mortgage companies, and “investment companies”. It is characteristic of all these
enterprises that they have a relatively small part of their assets in the form of material things but on
the other hand most categories have short- term obligations well in excess of their stock capital. the
shares of financial concerns have produced investment results similar to those of other types of
common shares.
 Railroad Issues

The railroad story is a far different one from that of the utilities. The carriers have suffered severely
from a combination of severe competition and strict regulation. Automobiles, buses, and airlines have
drawn off most of their passenger business and left the rest highly unprofitable; the trucks have taken
a good deal of their freight traffic. More than half of the railroad mileage of the country has been in
bankruptcy at various times during the past 50 years. There is no compelling reason for the investor to
own railroad shares; before he buys any he should make sure that he is getting so much value for his
money that it would be unreasonable to look for something else instead

Selectivity for the Defensive Investor

A highly trained analyst ought to be able to use all his skill and techniques to improve substantially on
something as obvious as the Dow Jones list. If not, what good are all his statistics, calculations, and
pontifical judgments?”. Suppose, as a practical test, we had asked a hundred security analysts to
choose the “best” five stocks in the Dow Jones Average, to be bought at the end of 1970. Few would
have come up with identical choices and many of the lists would have differed completely from each
other. Each analyst therefore gives a different advice and there is never unanimity. If all analysts
agreed that a certain share was better than the rest, that issue would quickly advance to a price that
offset all the previous benefits.

Every competent analyst looks forward to the future rather than backward to the past, and he realizes
that his work will prove good or bad depending on what will happen and not on what has happened.
Nevertheless, the future itself can be approached in two different ways, which may be called the way
of prediction (or projection) and the way of protection.

Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company
will accomplish in future years—in particular whether earnings will show pronounced and persistent
growth. These conclusions may be based on a very careful study of such factors as supply and
demand in the industry or volume, price, and costs—or else they may be derived from a rather naï ve
projection of the line of past growth into the future. If these authorities are convinced that the fairly
long-term prospects are unusually favorable, they will almost always recommend the stock for
purchase without paying too much regard to the level at which it is selling.

By contrast, those who emphasize protection are always especially concerned with the price of the
issue at the time of study. Their main effort is to assure themselves of a substantial margin of
indicated present value above the market price—which margin could absorb unfavorable
developments in the future. Generally speaking, therefore, it is not so necessary for them to be
enthusiastic over the company’s long-run prospects as it is to be reasonably confident that the
enterprise will get along.

The first, or predictive, approach could also be called the qualitative approach, since it emphasizes
prospects, management, and other nonmeasurable, albeit highly important, factors that go under the
heading of quality. The second, or protective, approach may be called the quantitative or statistical
approach, since it emphasizes the measurable relationships between selling price and earnings, assets,
dividends, and so forth. Incidentally, the quantitative method is really an extension—into the field of
common stocks—of the viewpoint that security analysis has found to be sound in the selection of
bonds and preferred stocks for investment.