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The

 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            
 

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