Investment Approaches and Selectivity for Defensive Investors

Key Insight

Security analysis employs two fundamental approaches: prediction and protection. The predictive, or qualitative, approach focuses on anticipating a company's future accomplishments, particularly persistent earnings growth, often based on industry analysis or projecting past growth. Adherents of this method might recommend stocks with favorable long-term prospects without significant regard for current price levels, as seen with past air-transport stocks despite inconsistent results. Conversely, the protective, or quantitative/statistical, approach prioritizes the current price of an issue. Its main goal is to secure a substantial margin of present value above market price, providing a buffer against unforeseen negative developments. This approach does not require enthusiasm for long-term prospects but reasonable confidence in the enterprise's viability.

The quantitative method is considered a natural extension of sound security analysis principles applied to bonds and preferred stocks. This perspective emphasizes obtaining ample, demonstrable value in concrete terms, rather than relying solely on future prospects and promises to offset a lack of current value. This contrasts with the prevalent view among many investment authorities who prioritize intangible factors like management quality and future prospects over historical records, balance sheets, and other 'cold figures.' The choice between these approaches highlights a fundamental disagreement within the investment community regarding how to identify the 'best' stocks.

For defensive investors, the recommended strategy is to eschew attempts at precise individual stock selection in favor of broad diversification. Diversification inherently counteracts ambitious claims of selectivity, as one would not diversify if unerringly capable of picking top-performing stocks. While certain asset classes like public utilities have historically offered attractive characteristics for defensive investors—such as strong performance records, greater price stability, and favorable price ratios compared to industrials, alongside higher dividend returns—the core principle remains to apply the same rigorous arithmetical standards for price relative to earnings and book value across all investments, including financial companies and, cautiously, even railroads. This disciplined approach, coupled with diversification, allows for some freedom of preference without compromising safety, while acknowledging the need to consider technological developments and find a balance between neglecting and overemphasizing them.