Principles of Common Stock Investment for the Defensive Investor

Key Insight

Common stocks are a crucial component of an investment portfolio, offering protection against inflation and historically delivering higher average returns compared to bonds, through dividend income and value increases from reinvested profits. However, these advantages can be lost if shares are purchased at excessively high prices, as observed in 1929 where it took 25 years for the market to recover. As of late 1971, with the DJIA at 900, common stocks generally lacked appeal, but a defensive investor must still include an appreciable proportion in their portfolio, viewing them as a lesser evil compared to holding only bonds.

The selection process for common stocks for a defensive investor should be straightforward, guided by four key rules. First, ensure adequate diversification with a minimum of 10 and a maximum of about 30 different issues. Second, each chosen company must be large, prominent, and conservatively financed, exemplified by having $50 million in assets or business, ranking in the top quarter or third of its industry, and with common stock representing at least 50% of total capitalization for industrials (30% for utilities). Third, companies should have a long record of continuous dividend payments, specifically starting no later than 1950.

Finally, investors must impose a strict limit on the price paid relative to earnings. This limit is suggested at no more than 25 times the average earnings over the past seven years, and not exceeding 20 times the earnings of the last twelve months. This restriction deliberately excludes most popular 'growth stocks,' which are characterized by high past and expected future earnings growth but typically sell at significantly high prices relative to earnings. Such high valuations introduce a substantial speculative element, making them too uncertain and risky for a defensive investor, even though individual growth stocks like International Business Machines have delivered phenomenal rewards but also experienced sharp declines (e.g., 50% in 1961–62 and 1969–70).