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.

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.

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.

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

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.

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.

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See Intelligent Investor Summary for other chapters summary.