In his classic, 'The Intelligent Investor', Benjamin Graham defined an investment as one, which upon thorough analysis promises safety of principal and an adequate return. Further, according to him, operations not meeting these requirements are deemed speculative in nature. Graham also differentiated between two types of investors - aggressive and defensive. The former, according to him is one who is enterprising and is willing to devote time to his stock selection. Such an investor would carefully select securities that are both sound and relatively more attractive than the average.
On the other hand, a defensive investor, according to Graham, is one who places high emphasis on avoiding serious mistakes or losses. Also, a defensive investor would aim at freedom from effort and the need for making frequent decisions. In this article, we would concentrate our efforts on defining the rules to be followed by a defensive investor while making his investment decision, keeping those for an aggressive investor for later times.
As mentioned earlier, a defensive investor should keep some benchmarks for himself while selecting his portfolio of stocks. Only this would be of help in his need for making less frequent decisions. However, this does not mean that a defensive investor should pick up stocks without considering his risk-return profile. For such kind of an investor, Graham outlined certain rules to be followed before taking any investment decision. In fact, these are some of the characteristics that a defensive investor should look at in a company.
Adequate size of the enterprise: Graham considers is one amongst the most important factors. This is because small companies or those that are in the nascent stages of their development are more likely to have a volatile future than bigger corporations. While an aggressive investor would have interest in such small yet growing companies, this should not be a defensive investor's cup of tea. He should be happy in having large and strong companies in his portfolio.
A sufficiently strong financial condition: Graham gives top priority to a sufficiently strong financial condition of a company. Investors should make sure that their investment target (company) has a strong balance sheet and profit and loss account, and a very strong cash flow statement. This is because, more than book profits, it is the strong cash position that is of help for the company in times of pressure and uncertainty. Specifically, Graham states that a manufacturing enterprise's current assets should be at least twice its current liabilities. This is to say that the current ratio should be at least 2. Also, for such companies, long-term debt should be less than the net current assets (or working capital).
Earnings growth and stability: For a company to be a sound investment target, not only should it have a history of decent earnings growth, but also stability in the same. A company with a volatile earnings growth history is more likely to be a risky proposition. By this, Graham probably means earnings after paying interest on debt, or what is left for equity investors.
Dividend growth: Regular dividend payments and consistent growth in payout (Dividends upon Earnings) is another indicator of the sound financial position of the company. While there might be instances when a growing company is ploughing back earnings towards future growth rather than paying large dividends, but investors must see that there are no grave inconsistencies in dividend payments.
Moderate P/E ratio: A moderate Price-to-Earnings ratio is a very useful indicator for a defensive investor. This is because a relative lower P/E would save investors from paying a very high price that does not justify the value of an investment. Also, a history of moderate or less-volatile P/E's also helps the investors' cause. This is because a company that has had volatile P/E's in the past is a case of investors building up 'irrational expectations' of its growth.
While Graham does not specifically mention about 'management quality' as an indicator for defensive investors, we believe that the presence of the abovementioned characteristics in a stock is in itself an indicator of a strong management. All said and done, while the rules mentioned above are benchmarks that every defensive investor needs to apply before making any investment decision, the fact that he should do his homework carefully should not lose relevance. This means that he should research well about the company's history, its business model and factor that are likely to affect its future performance. Also, the investor should have a long-term (2 to 3 years) investment horizon for only then would he realise adequate returns to his investments.
Note: Characters in italics are quotes from Benjamin Graham.