“All knowledge is cumulative.” -Mohnish Pabrai
The other day I was driving around listening to Ben Graham’s The Intelligent Investor “book on CD” that I received as a gift last year. I first read The Intelligent Investor 7 years ago, and it changed the way I think about investing, as it does for many others who read it for the first time.
I’ve read the book twice, but I’ve listened to the CD about six or seven times since getting it last fall. There are three CD’s in all, and it only takes a bit over two hours to listen to the entire book. So it’s easy to listen to, plus I always leave it in my CD player in my car, so it automatically comes on whenever I get in the car, making it easy to listen to while I drive (and very annoying for my wife whenever she’s in the car with me… she doesn’t seem to appreciate the benefits of repetition).
Even after reading/listening to the book over a half dozen times, I still find that there is usually something to learn from Graham, even now as I firmly understand Graham’s principles. Repetition creates layers of understanding that compound on top of each other, and it can lead to good ideas, or simply just further understanding of the foundation and principles of value investing.
Today I thought I’d bring up Graham’s rules for the Defensive Investor. This was the last passage I just listened to from the book. For those that aren’t familiar with Graham’s teachings, he basically divides investors into 2 separate categories:
- Enterprising-Active investors who have the time and skill to analyze stocks in an attempt to outperform the market averages
- Defensive-Passive investors who either don’t have time or the skill to actively analyze securities, but nonetheless want a satisfactory return while preserving the safety of their principal.
So the Defensive, or Passive Investor has the goal of assembling a portfolio of of quality stocks with long histories of profitability at low to fair valuations. The result is a low maintenance, low turnover portfolio of good companies. (Note: Graham was a big believer in balancing portfolios with stocks and bonds, especially for the Defensive Investor, but these rules of course apply only to the stock portion of the portfolio).
Here are Ben Graham’s 4 Rules for the Defensive Investor:
- Should diversify, but not overdiversify (10-30 stocks)
- Should own large companies that are in stable businesses
- Stocks should have a long history of dividend payments. He wrote the book in 1972 and suggested dividends dating to 1950 (so 20-25 years of dividend history he’s looking for)
- Should not overpay: should pay less than 25 times average earnings of the last 7 years, and not more than 20 times the last 12 months
Notice how these rules don’t mention anything about book value or balance sheet consideration (at least not directly; he implies that these should be quality companies which would presumably mean companies with healthy balance sheets, but most of the emphasis on valuation revolves around earnings and dividends). This is contrary to the “net-net” school of Graham, which is more focused on finding deep value stocks, and more geared toward the Enterprising Investor.
The 4th rule is interesting because a stock that is selling at say 18 times earnings would qualify (given the other conditions), and that valuation is not exactly what you’d call cheap. But Graham was interested in stocks that could be held for years. I think he was encouraging the Defensive Investor to look for “wonderful businesses at fair prices”. He wanted stocks that were consistently paying out (and presumably growing) their dividend distributions.
Graham became much more quantitative in his later years, and I’ll discuss some of his systematic value ideas in later posts. But it’s interesting to think about his thoughts for passive investors, and to consider what companies he might be interested in holding today. One place to start would be the list of stocks that have grown their dividends for 25 years or more. (Thanks to DripInvestor.org).
Again, these rules are geared toward passive investors. Graham himself averaged 20% per year for over 20 years with his private partnership using different strategies, but similar value investing principles. We’ll discuss much more of this over time on this blog…