In a book called ‘The Intelligent Investor’ by Benjamin Graham, the author has categorised investors into two types: Defensive and Enterprising investors.
In this book, Benjamin Graham suggests which type of stocks is suitable for which type of investor. This kind of know-how is particularly helpful for beginners. Even experienced investors can take clues from it and refine their stock picking methodology.
The points explained by Graham in his book is not only logical but also seems to satisfy the overall theme of value investing.
But before we go into the details, lets know a bit about whom Benjamin Graham calls as “defensive” and “enterprising” investor.
These days these type of investors are more commonly addressed as “passive investors”. These investors like to invest their money in stocks, but they would not like to be actively involved in the whole process. They are like “invest-it and forget-it” type of investor. Hence they are okay with only average returns from stocks.
These investors are very sensitive to mistakes. They would rather compromise slightly on returns than to face a potential after-effects of mistakes. They are also critical of loss-making in stock investing.
In short, we can say that these investors prefer to take decision ‘one time’ instead having to do it repeatedly (like buy-sell calls). Hence, according to Benjamin Graham, defensive investors should prefer investing in stocks of a certain type
These days we also know them better as “active investor”. These investors has time, interest and energy to remain actively involved in the stock market.
The focus of these investors is high-returns. Hence they prefer to go aggressive in both stock picking and decision making.
As enterprising investor has to undertake more decision within a period of time (as compared to defensive investor), hence they keep their stock picking skills more refined. Their ability to do fundamental analysis of stocks is more deep and accurate.
Hence, according to Benjamin Graham, enterprising investors can afford to invest in more riskier stocks.
Stock Rules for defensive investor
Being a defensive investor, why they should care about stocks (equity) at all? Because this is the only way they can prevent their money from the wrath of inflation. Investing in stocks can generate higher returns in long term. These returns will be considerably more than savings and debt based plans.
But here comes the word of caution. No matter how good is the underlying company behind the stock, or how long the stocks are being held, it will not yield expected returns till a care is taken about its “buy price”.
It is extremely important NOT to buy stocks at overvalued price levels. Moreover, extra care must be taken to buy them at a ‘margin of safety‘.
The rules that defensive investors can follow to pick their stocks are the following:
- Rule#1 (Avoid Excessive Diversification): Defensive investors should spend more time analyzing stocks of the business. Instead of going on buying all kind of stocks, defensive investors should focus on few stocks only. Their portfolio shall consist of between 10 to 30 number stocks.
- Rule#2 (Type of Company): Graham suggests that, defensive investors should buy stocks of a certain type of companies.
- Size: First, these companies should be large. He limits the size as $100 million (Rs.20K Crore) in annual sales, and $50 million (Rs.10K Crore) in total asset. [I’ve considered Inflation @6.6% and USD-INR conversion rate of Rs.70].
- Second: All these companies must be “conservatively financed”. In simple words we can say that they should be low debt or debt free companies.
- Third: The financials of these companies shall be strong. The ratio between current assets and current liability shall not be less than two (current ratio). The ratio between debt and equity shall not be more than 2 (for industrial companies).
- Fourth: There must be an earning stability. The company should have posted some profits in last 10 years in a row.
- Fifth: The company must post at least 33% growth in EPS in last 10 years. How to calculate the growth rate? Record last 10 years EPS. Take average of first 3 years, then take average of last 3 years. Last 3 years avg. earnings shall be at least 1.33 times the first 3 years avg. earnings.
- Rule#3 (Dividend Paying): Focus of defensive investor should be on dividend income rather than price appreciation. Stocks of good dividend paying companies is preferable. How to identify such companies? They should have paid dividends continuously for last 20 years.
- Rule#4 (Price Limit): There should always be an upper limit on the price that a defensive investor shall pay for a stock. How to decide on the price limit?
- P/E Rule: By fixing a P/E multiple. This multiple screener shall be applied in three folds: (a) 20 times the average EPS of last 7 years, (b) 20 times the average EPS of last 12 months, (c) 15 times the average EPS in last 3 years.
- P/B Rule: In addition to P/E rule, the price must also follow the price to book value rule. Price to book value ratio shall not be more than 1.5.
- PExPB Rule: The product of P/E and P/B shall not exceed 22.5. Example: P/E = 18 and P/B = 1.2. In this case PE multiplied by PB is 21.6.
Before we can conclude the topics, let’s understand the rational behind Benjamin Graham’s logic about ‘large companies’.
Investing in unpopular large company
Do you know a fundamental law of stock market?
It tends to overvalue stocks which are showing good growth rates. Similarly it also tends to undervalue stocks which is not showing as good results for some temporary reasons. This is a common market behaviour.
What we can learn from this fundamental law? According to this law, there is a tendency of investors to continue focusing on large companies even when they are going through a phase of lower earnings.
This behaviour of investors keeps the price of such large companies from falling too low even if their underlying business performance is not up to the mark.
On the contrary, smaller companies, which are not as visible as large companies, might remain undervalued even if they are recent earnings are showing a reasonable growth numbers.
What does this mean?
Large companies mostly remain in favour. Why? Because they have more capital resource and human resource. So even if they are in a temporary problem, their chances of getting out are more certain. Hence investors tend to show more faith in large companies. As a result, price of shares of such companies can resist downside movement more surely.
Large companies shown another advantage. The possibility of seeing a quick price-uptrend is more certain. How? As the focus of investors are always on large companies hence a relative improvement in their profits/EPS is applauded by the market rather quickly.
Unfortunately smaller companies do not enjoy the dual advantage of larger companies.
What defensive investors can do?
They shall first focus on those companies which are large but are presently unpopular in the market. The investors should buy stocks of these companies. Once the stock is purchased the investor should continue to hold these stocks for at least next 3-4 years.
What they investors cannot do?
They should not get lured into buying stocks of smaller companies which looks undervalued in present circumstances. Why so? Because those small companies, maybe they are doing good business, but may continue to remain unpopular in the market.
Purchasing Undervalued Stocks
What are undervalued stocks? These are those stocks which are trading at a price level below its fair price. How to establish the fair price? The fair price can be established upon prudent fundamental analysis of its underlying business.
This is a situation where we can say that a “discrepancy exists” in the stock. What is the discrepancy? The discrepancy is between the stocks fair price and its current market price.
In accordance with the business fundamentals of the company, fair price comes out to be higher than the current market price. As this situation rarely exists for large companies – hence investors tend to call this situation as a ‘discrepancy‘.
How investors can benefit from the discrepancy?
Before one can benefit from this discrepancy it is first important to know “how to analyse stock price“. There can be two methods of analysing the fair price:
- First: Look at the historical (10 year) P/E ratio. It will give an impression that what is that P/E ratio which this company tends to hold under normal circumstances. Let’s call it a “sustainable P/E (SPE)” ratio. Next, look at the historical EPS. By looking at the past 10 years EPS, one can judge what will be the “forward EPS” (five years from now – FEPS-5Y). Then, multiplying SPE and FEPS-5Y. This will give an idea of the future fair price of stock. If the current price is considerably less than the estimated future fare price, it means that the stock is undervalued. Read this.
- Second: This method of analysis is also based on estimating the future earnings of the company. But the comparison of future earnings of the company is made with the net current asset (NCA) of the company (NCAVPS method). [Note: In the first method we compared future earnings with price, here we’r comparing with NCA]
Stock Rules for enterprising investors
Investors in general pay more weight to future growth prospects of a company. Hence they are ready to pay a premium to such companies which has chances of fast growth in times to come.
Such companies often trade at high P/E multiples. Why? Because they are often among the “most favoured stocks” of the market. Enterprising investors must keep a note of it. Why?
Because buying stocks of such companies means, focusing only on growth prospects, price valuation part may get ignored. But to profit form stocks, balance must be there between future growth prospects and the price one pays to buy that stock.
Enterprising investors should invest their time and energy in identifying those companies which has a reasonable growth prospects but are currently out of favour.
Let’s see how enterprising investors can screen their stocks.
Stock screening criteria:
- Financially Sound Company: How to judge it? This can be done in two ways: (a) Current assets should be 1.5 times the current liability, (b) total debt should not be more than 110% of net current assets (for industrial companies).
- Stable Earnings: Investor shall look at last five years earnings. Firstly, there should not be any deficit (loss) in earning in last 5 years. Secondly, the earning trend of last five years shall depict stability and not volatility.
- Pays Dividends: Companies with sound financials and stable earnings, if they also pay dividends, it is a positive signal. Dividend yield need not be high, but there must be some dividend paid in last years (specially in current year).
- Earnings Growth: In last five years, there must be an earning growth. I would personally like to add here that, instead of looking only at net profits, enterprising investors shall also see EPS growth.
- Price Limit: First look for the “net tangible assets” of the company. You’ll find it in its balance sheets. Net tangible asset is nothing but the book value (Total asset minus total debt). The current price of the stocks shall be less than 120% of book value.
These rules stated in book (The Intelligent Investor’ by Benjamin Graham), are old but timeless. Though these days we use more fancy valuation models for stock analysis. But for most common men, those methods simply do not work. Why? Because they are complicated to implement.
Hence, if such investors can apply the above stated rules, they may find some quality stocks – even today.