Intelligent Investor Chapter 14 Summary: Stock selection for the defensive investor

Stock selection for the defensive investor:

  • Two options: 1)DJIA type portfolio: buying same amounts(~10 shares each) of all thirty of issues - basically a low cost index fund 2) Quantitatively tested portfolio
  • Quantitatively tested portfolio: Minimum of quality in past performance and current financial position, minimum of quantity in terms of earnings and assets per dollar of price. These were covered in previous chapter's 7 criteria:
    • Adequate size of the Enterprise: Exclude small sized companies.
    • Strong financial condition: two-to-one current ratio - current assets/current liabilities. Long term debt shouldn't exceed net current assets/working capital. For public utilities, debt shouldn't exceed twice the stock equity at book value.
    • Dividend record for past 20 years.
    • Some earnings for common stock in each of past 10 years.
    • Min increase of at least 1/3 in EPS in past 10 years using 3 year averages.
    • Current price shouldn't be more than 15*(average earnings of past 3 years).
    • Current price shouldn't be more than 1.5*(book value). But sometimes a low multiplier of earnings below 15 justifies the high multiplier of assets. Product of both multipliers shouldn't exceed 22.5.
  • These exclude companies that are small, have weak financial condition, have deficit in 10 years, have no long history of dividend payments.
  • Factor of safety: too large portion of price must not depend on future earnings.
  • Growth companies can be included only if they are available at bargain prices.
  • Reverse of P/E : E/P should be at least as high as current high grade bond rate.

Public utility stocks:

  • Current assets/current liabilities criteria may be excluded for these, as working capital factor takes care of itself through continuous financing by bonds and shares.
  • Price should be moderate compared to book value.
  • Not as great as industrial index, but price stability is more.
  • If they advance excessively, it's better to sell and pay tax as there's a danger of these getting replaced by issues with reasonable prices.

Investing in stocks of financial enterprises:

  • Fixed assets portion is quite less for these, but they have enough short term obligations that need capital. This led to many regulations and supervision.

Railroad issues:

  • Severe competition and strict regulations. Went bankrupt many times. But their earnings were good during war time. Airline stocks are on similar lines.

Selectivity for the defensive investor:

  • Efficient markets hypothesis:  Price of stock incorporates all publicly available information about the company. This isn't always right. Current price reflects facts and future expectations. As two Finance professors walk outside, they see a $20 bill. One of them thinks about picking it up but then changes his mind: “If it really were a $20 bill, someone else would’ve already picked it up.” 
  • Two ways to approach future:
    • Prediction/projection/Qualitative: We invest in present, but we invest for the future, which is uncertain. Investing on the basis of projection is just anticipating.Non-measurable.
    • Protection/Quantitative/Statistical: Based on current price and assuring for any margin in current value as above market price- which could absorb unfavorable future conditions. Measurable.
  • Diversify


  • Start with total stock market index as foundation and then experiment with 90:10 in index vs picking stocks.
  • Diversification: Microstrategy, sought as the next Microsoft went from 3K to 15 in two years.
  • Choose mutual funds if you want to consider small companies.
  • Hot companies that go cold later will have good current ratio and thus financial stability.
  • Consider 50%(2002) earnings growth against Graham's 33%(1970).
  • Forward P/E ratio is non-sense.
  • Check company reports along with proxy statements.
  • Check who owns major portion of shares. Big institutes sell their bulk shares leading to disastrous results.

See Intelligent Investor Summary for other chapters summary.


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