Defensive Investor's Stock Selection Principles

Key Insight

For a defensive investor, security selection involves either acquiring a true cross-section sample of leading issues, like buying equivalent amounts of all thirty Dow-Jones Industrial Average (DJIA) stocks, or applying a set of minimum quantitative and qualitative standards to individual purchases. The DJIA-type portfolio, for example, could cost approximately $16000 for ten shares of each at the 900 level for the average. The alternative involves rigorous criteria, ensuring a minimum of quality in past performance and financial standing, alongside sufficient earnings and assets relative to price.

Seven key criteria for selecting common stocks include: adequate enterprise size (e.g., at least $100 million in annual sales for industrials or $50 million in total assets for utilities); a strong financial condition (current assets at least twice current liabilities for industrials, with long-term debt not exceeding net current assets; for utilities, debt not exceeding twice stock equity); earnings stability (some earnings in each of the past ten years); an uninterrupted dividend record for at least 20 years; and earnings growth (a minimum one-third increase in per-share earnings over the past ten years, using three-year averages).

Further criteria focus on valuation: a moderate Price/Earnings (P/E) ratio, where the current price should not exceed 15 times the average earnings of the past three years; and a moderate Price to Assets ratio, with the current price not exceeding 1.5 times the last reported book value. The product of the P/E multiplier and the price to book value ratio should ideally not exceed 22.5, allowing for flexibility, such as an issue selling at 9 times earnings and 2.5 times asset value. These standards aim to eliminate small or financially weak companies, those with a deficit history, or a short dividend record, while also excluding popular but potentially overpriced issues that lack an adequate factor of safety. The objective for the stock portfolio is to have an overall earnings/price ratio at least as high as the current high-grade bond rate, implying a P/E ratio no higher than 13.3 against a 7.5% AA bond yield, resulting in a typical portfolio P/E of around 12 to 13 times.