Seven Tests of Defensive Stock Selection

Keys to Putting Together a Conservative Portfolio of Common Stocks

Each autumn, I read Benjamin Graham's Intelligent Investor.  It's principles are timeless, unquestionably accurate, and contain a sound intellectual framework for investing that has been tested by decades of experience.  As I considered the content of my weekly article, I decided to focus on the seven tests prescribed by Graham in Chapter 14, Stock Selection for the Defensive Investor.  Each of these will serve as a filter to weed out the speculative [or 'risky'] stocks from a conservative portfolio.

1. Adequate Size of the Enterprise
In the world of investing, there is generally some safety attributable to the size of an enterprise.  A smaller company is generally subject to wider fluctuations in earnings.  Graham recommended [in 1970] that an industrial company should have at least $100 million of annual sales, and a public utility company should have no less than $50 million of total assets.  Adjusted for inflation, the numbers would work out to approximately $465 million and $232 million respectively.

2. A Sufficiently Strong Financial Condition
According to Graham, a stock should have at least a current ratio of two.  Long-term debt should not exceed the working capital.  For public utilities the debt should not exceed twice the stock equity at book value.  This should act as a strong buffer against the possibility of bankruptcy or default.

3. Earnings Stability
The company should not have a reported loss during any of the last ten years.  Companies that can maintain at least some level of earnings are generally more stable.

4. Dividend Record
The common stock should have a history of paying dividends for at least the past twenty years.  This should provide at least some assurance that future dividends are likely to be paid.

5. Earnings Growth
To guarantee the company's profits at least keep pace with inflation, the increase should be at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price to Earnings Ratio
For inclusion into a conservative portfolio, the current price of a stock should not be more than 15 times its average earnings for the past three years.   This should help to assure that the investor has not paid too much for his or her shares.

7. Moderate Ratio of Price to Assets
Quoting Graham, "Current price should not be more than 1 1/2 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 (this figure corresponds to 15 times earnings and 1 1/2 times book value.  It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)"

More Information on the Intelligent Investor
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Copyright © 2002 Joshua Kennon