This guest article why a Ben Graham defensive investor should use the Graham number was written by Net Net Hunter member Kevin Pumphrey. The opinions expressed here may or may not reflect those of anyone else at Broken Leg Investing. Creative Commons photo by Jim Linwood.
Ben Graham would probably have adopted KISS for his defensive investor.
KISS – Keep it simple, stupid. This isn’t an insult – it’s a prescription.
Profiting from common stock investment can be difficult to accomplish, and even more so to keep the profits. For some investors, adhering to the classic “set it and forget it” portfolio policy is the most effective way to achieve their long-term investment goals. Further, sometimes investors feel most comfortable when the equity portion of their portfolios are only exposed to well-established, long-profitable and financially stable businesses.
To be sure, the choice between passive and aggressive styles comes down to time, risk tolerance, temperament and preparedness. This, of course, varies from person to person. Unfortunately, there is no holy grail, magic bullet, one size fits all strategy that will be perfect for everyone’s needs.
For those that lack the time, interest or appropriate skill for active investing, Ben Graham’s Defensive Investor criteria offer a time-tested winning strategy for passive investment. Bear in mind that of Buffett’s many great aphorisms, “Investing is simple but not easy” is a nod to our human capacity to, at best, complicate things and at worst, be our own worst enemy. This is especially true of investing.
In 1949, Benjamin Graham wrote what Warren Buffett has called “the best book about investing ever written.” Specifically addressed to the layman, The Intelligent Investor is truly a masterpiece. From portfolio weighting between stocks and bonds, to the now legendary parable of Mr. Market, and to what eventually became known as The Graham Number; The Intelligent Investor seems to be the gift that keeps on giving. If you’re a serious investor and you haven’t read this book, do yourself a favor and bump it to the top of your list. I have read it 5 times and take away something new every time.
In The Intelligent Investor, Graham addresses two classes of investors; The Defensive Investor, and the Enterprising Investor. The Enterprising or active investor is intent on applying maximum intelligence and skill upon his investment operation and could generally expect a worthwhile reward for his extra time and effort.
The defensive investor, on the other hand, either due to lack of time, lack of interest, or perhaps an undeveloped understanding of investment principles, would seek to maximize their long-term returns and lowering portfolio volatility while remaining free from bother or frequent decision making. The defensive investor would also be willing to accept a lower, but still respectable overall return on his or her capital than their enterprising counterpart. It should be noted, however, that like the enterprising strategies, the defensive strategy has been shown to consistently outperform the averages over long periods of time.
For the defensive investor, Graham prescribed 2 overarching guidelines. That of quality as shown in the company’s past performance, and its current financial position. Secondly, that of minimum quantity with respect to price paid for earnings and assets. The Graham Number itself is a derivative of the two quantity rules. The rules are specifically laid out in Chapter 14: Stock Selection for the Defensive Investor and are listed as follows:
- Moderate Price/Earnings Ratio – Current price should not be more than 15 times the average earnings of the past 3 years.
- Moderate Ratio of Price to Assets - Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.
The two above rules create the framework for the Graham Number. Using the equation:
This formula evaluates to the maximum price a defensive investor may pay for any stock in his portfolio and is, indeed, still relevant today for identifying reasonably priced, defensive stocks. You’ll probably also notice that Broken Leg Investing’s Simple Way 2.0 strategy follows very close to Graham’s original criteria for the defensive investor. This is not by accident, since it’s an upgraded version of Graham’s original simple way strategy.
The reader should note that what is frequently overlooked is that the price paid (e.g. The Graham Number) is only part of the defensive investor’s selection criteria. Graham elaborated that the defensive investor must first filter for quality and financial strength. Graham’s quality rules for defensive stock selection are listed as follows (descriptions taken from The Intelligent Investor):
- Adequate Size of the Enterprise - All our minimum figures must be arbitrary and especially in the matter of size required. Our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field. (There are often good possibilities in such enterprises but we do not consider them suited to the needs of the defensive investor.) Let us use round amounts: not less than $100 million (500M inflation-adjusted) of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.
- A Sufficiently Strong Financial Condition - For industrial companies, current assets should be at least twice current liabilities—a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or “working capital”). For public utilities the debt should not exceed twice the stock equity (at book value).
- Earnings Stability - Some earnings for the common stock in each of the past ten years.
- Dividend Record - Uninterrupted payments for at least the past 20 years.
- Earnings Growth - A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
Notice that the quality criteria make up 5 of the 7 rules for defensive selection. This is important, and consistently overlooked. Without factoring these quality rules into one’s selection process, the investor may well find that he/she has not performed well, and perhaps has done substantially worse than the market averages. This is a common mistake and should thus be avoided.
This simple and relatively passive approach has, indeed, performed and continues to perform well over many years. In fact, as of 10/31/17 the AAII’s Graham Defensive Investor strategy has earned 14.5% per year since inception against 5.2% for the S&P. From the volatile period of 1998-2009, the defensive screen earned a cumulative 269.5% or 12.62% CAGR vs. a cumulative loss of 17.8% for the S&P. Interestingly, this is not far behind the performance of our Simple Way 2.0 strategy.
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioural discipline that are likely to get you where you want to go.”
- Ben Graham
So friends, even a defensive investor’s portfolio, with its vapid simplicity, can trounce the market over long stretches of time. While remaining relatively free from worry or bother, the defensive investor plods along by primarily limiting downside. He uses the Graham Number in the context of its qualitative brethren, making sure to rebalance once per year — a tradition we hold dear in our own investment letter.
As we do with a focus on long term performance - the defensive investor disregards the wild fluctuations of the market, and sleeps soundly knowing that his holdings consist of financially stable, profitable businesses which were all purchased at a reasonable price.
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