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Intelligent
Investor
Chapter
5:
The
Defensive
Investor
and
Common
Stocks
• In
the
original
1949
publication
of
The
Intelligent
Investor
Graham
offered
two
main
arguments
for
the
inclusion
of
common
stocks
in
the
defensive
investor’s
portfolio
• Common
stocks
offer
a
considerable
degree
of
protection
from
the
dollar’s
erosion
during
a
period
of
inflation
when
compared
to
bonds
• The
average
return
on
common
stocks,
through
dividend
income
and
market
value
increases,
has
historically
been
higher
than
bonds
• These
advantages
can
be
negated
if
the
stock
buyer
pays
too
high
of
a
price
for
his
shares
• There
are
four
rules
the
defensive
investor
should
consider
when
selecting
common
stocks
for
his
portfolio
• There
should
be
adequate
though
not
excessive
diversification.
Ideally
the
portfolio
should
consist
of
between
ten
and
thirty
stocks.
• Each
company
selected
should
be
large,
prominent
and
conservatively
financed.
• Each
company
should
have
a
long
record
of
continuous
dividend
payments.
• The
investor
should
impose
a
limit
on
the
price
he
will
pay
for
an
issue
in
relation
to
its
average
earnings
over
the
past
seven
years.
Twenty
five
times
the
last
seven
years
average
earnings
and
twenty
times
the
past
twelve
months
earnings
is
a
reasonable
limit.
• It
is
acknowledged
by
the
author
that
this
criteria
eliminates
the
vast
majority
of
growth
stocks
• Growth
stocks
are
defined
as
companies
who
have
increased
their
per-‐share
earnings
at
a
rate
well
above
the
market
and
are
expected
to
continue
to
do
so
into
the
future
• Selecting
successful
investments
from
this
pool
of
stocks
is
difficult
because
they
sell
at
high
multiples
of
their
current
earnings
• Because
future
growth
is
always
uncertain
paying
high
multiples
of
current
earnings
for
growth
stocks
is
a
speculative
endeavor
• Typically
with
growth
stocks
price
increases
even
more
rapidly
than
earnings
• When
earnings
stop
increasing,
or
even
decline,
violent
price
corrections
are
common
• For
the
defensive
investor
large
companies
obtainable
at
reasonable
earnings
multiples
are
a
more
sound
investment
strategy
• Graham
suggests
that
the
defensive
investor
consult
an
advisor
annually
regarding
the
safety
of
his
portfolio
• It
is
critical
that
his
advisor
be
reputable
and
trustworthy
• The
investor
should
make
it
clear
to
his
advisor
that
he
must
follow
the
four
rules
of
common
stock
investing
listed
above
• Frequent
trading
of
the
portfolio
is
a
red
flag
that
the
advisor
does
not
understand
the
construction
of
a
defensive
portfolio
• Dollar-‐cost
averaging,
or
buying
the
same
dollar
amount
of
common
stocks
every
month,
is
a
technique
suitable
for
the
defensive
investor
• Regardless
of
age,
available
finances
and
income
level
if
the
investor
chooses
to
be
defensive
he
should
invest
using
the
same
methodology
• The
beginning
investor
should
not
commit
large
sums
of
money
to
the
task
of
trying
to
beat
the
market
• Initially
he
should
study
security
values
and
test
his
judgment
on
small
sums
of
money
• The
types
of
securities
to
be
purchased
and
the
desired
rate
of
return
do
not
depend
on
financial
resources
but
on
knowledge,
experience
and
temperament
• The
distinction
between
risk
and
safety
is
very
important
for
the
investor
to
understand
• A
bond
is
unsafe
if
it
defaults
on
an
interest
payment
and
a
stock
is
unsafe
when
its
dividend
is
reduced
or
eliminated
• An
investment
is
also
risky
if
there
is
a
strong
possibility
that
it
will
have
to
be
sold
at
a
level
below
cost
• Risk
should
not
be
associated
with
the
possible
decline
in
a
security
price
at
a
time
when
the
owner
is
not
forced
to
sell
• Risk
is
the
loss
of
value
which
is
realized
through
actual
sale
of
the
company,
significant
deterioration
in
the
company’s
financial
position
or
the
payment
of
an
excessive
price
in
relation
to
the
company’s
intrinsic
worth
• Price
fluctuations
on
the
other
hand
are
not
a
form
of
risk
• A
bit
of
further
clarification
on
the
definition
of
“large,
prominent,
and
conservatively
financed
companies”
• Industrial
companies
are
conservative
if
the
book
value
of
their
common
stock
represents
half
of
the
total
capitalization
• Public
utilities
are
conservative
if
that
figure
is
at
least
30%
• Large
and
prominent
refers
to
substantial
size
and
leading
position
in
the
industry
• Commentary
on
Chapter
5
• “Human
felicity
is
produced
not
so
much
by
great
pieces
of
good
fortune
that
seldom
happen,
as
by
little
advantages
that
occur
every
day.”
-‐
Benjamin
Franklin
• How
defensive
you
should
be
as
an
investor
is
determined
by
how
much
time
and
energy
you
are
willing
to
put
into
your
portfolio,
not
by
risk
tolerance
• Your
willingness
to
own
stocks
should
be
based
on
whether
or
not
they
are
priced
reasonably
enough
to
offer
future
growth
§ Past
investing
mistakes
should
not
dampen
your
outlook
toward
common
stocks
going
forward
• This
is
especially
true
when
the
yield
on
bonds
are
very
low
offering
the
investor
less
in
the
way
of
income
• During
the
1990’s
Peter
Lynch,
former
manager
of
the
Fidelity
Magellan
fund,
became
popular
for
advising
investors
to
buy
stocks
of
companies
that
they
use
on
a
daily
basis
§ Lynch
encouraged
investors
to
use
their
natural
intuition
to
buy
into
companies
of
products
they
are
familiar
with
§ He
clearly
stated
that
finding
an
investment
you
are
familiar
with
is
only
the
first
half
of
the
battle
§ The
second
step
is
to
do
the
research
on
the
company
and
estimate
its
business
valuation
§ Many
stock
buyers
in
the
1990’s
ignored
the
second
part
of
the
process
• Some
investors
used
Lynch’s
philosophy
as
confirmation
that
it
was
ok
to
put
100%
of
their
401(K)
into
their
employer’s
stock
• This
lead
to
disastrous
results
in
some
instances
• Investing
in
what
you
know
best
can
be
dangerous
because
you
are
less
likely
to
probe
deeply
for
potential
weaknesses
in
the
company
• The
more
familiar
a
defensive
investor
is
with
a
stock
the
more
likely
they
are
to
become
lazy
in
their
analysis
• Discount
brokerages
available
on
the
internet
have
made
creating
a
defensive
portfolio
extremely
simple
• Graham’s
suggestion
of
ten
to
thirty
stocks
in
the
defensive
portfolio
remains
a
sound
starting
point
• If
the
defensive
investor
finds
himself
spending
more
than
an
hour
per
month
on
his
portfolio
or
trading
more
than
twice
per
year
he
should
hand
over
the
reins
to
someone
else
• There
is
no
shame
in
trusting
your
portfolio
to
an
advisor,
but
it
is
always
the
investor’s
responsibility
to
make
sure
the
advisor
is
trustworthy
and
charges
reasonable
fees
• Carefully
selected
mutual
funds
and
index
funds
are
both
viable
options
for
the
defensive
investor
• The
defensive
investors
greatest
weapon
is
his
refusal
to
be
active
and
willingness
to
admit
that
he
does
not
know
where
the
market
is
going
• When
the
portfolio
is
on
autopilot
it
eliminates
self-‐delusion
and
the
ability
for
the
market
to
upset
you
• This
is
another
reason
why
Graham
favors
dollar-‐cost
averaging
for
the
defensive
investor