Description

The Defensive Investor stock screen was made popular by Benjamin Graham. In The Intelligent Investor, Graham identifies two categories of investors; the defensive and the enterprising. According to Graham, a defensive investor buys from a “diversified list of leading common stocks” and ensures that the price paid is “not unduly high as judged by applicable standards.” Here, we display such a list based on the requirements spelled out by Graham.

Chapter 14 of The Intelligent Investor is titled “Stock Selection for the Defensive Investor.” In this chapter Benjamin Graham lays out “seven statistical requirements for inclusion in a defensive investor’s portfolio.” The first five criteria are concerned with the company’s “past performance and current financial position,” while the last two requirements are concerned with the stock’s price relative to the company’s earnings and asset values.

Core Criteria

The five qualifying characteristics a Defensive Investor stock must have in order to be considered for purchase are: adequate size, financial stability, consistent profitability, uninterrupted dividends, and increased earnings.

• Graham wanted to eliminate small companies with less stability so he suggested companies with more than $100 million in annual sales. To adjust for inflation and simplify this criteria, we only include stocks with a market capitalization (stock price multiplied by the number of shares) greater than $2 billion. Anything less is typically considered a small cap stock.
• In an attempt to ensure only financially strong companies are considered, Graham wanted companies with current assets at least twice as high as current liabilities AND long-term debt no more than the difference between current assets and current liabilities. We filter for companies with a current ratio greater than 2 and working capital greater than long-term debt.
• To identify consistently profitable companies, Graham looked for companies which reported positive earnings in each of the last 10 years. We follow Graham’s requirement and eliminate any company with negative earnings in the last decade.
• For Graham, cash dividends were a sign that management “thought like owners” and was concerned with increasing shareholder value. He recommended stocks that continuously paid a dividend for at least 20 years. We are not as stringent as Graham but include only stocks that have paid a dividend for a minimum of 10 years in a row.
• It was important to Graham that a Defensive Investor look for companies which have experienced consistent growth over several years. To find these companies, Graham suggested companies with a minimum increase of at least 33% in per-share earnings in the past 10 years using 3-year averages at the beginning and end. That comes out to roughly a 3% growth rate per year. To simplify this criteria, we only include stocks with a 5-year net income CAGR (compounded annual growth rate) of at least 3%.

Valuation Factors

The above criteria considerably narrows the field of investable stocks for a Defensive Investor. Just because a company meets all those requirements, does not necessarily mean it is a good investment. Whether or not a good business is a good investment depends on the price paid. Graham said Defensive Investors need to ensure that the price paid for their list of “leading common stocks” is “not unduly high for applicable standards.” For this screen, Graham’s “applicable standards” are determined based on a stock’s price in relation to its earnings and the book value of the company.

• To guarantee a moderate price to earnings, Graham required that the current price should not be more than 15 times the company’s three-year average earnings.
• Likewise, when ensuring the price is sufficient relative to the company’s book value, Graham didn’t want the current price to be more than 1.5 times the book value reported in the most recent quarter (MRQ).
• When calculating the intrinsic value for the Defensive Investor screen, we average the above valuation factors. For example, if the 3-year average earnings per share is $5 and the book value per share is $30, the intrinsic value would be $60/share.
  • 3-year average EPS = $5
  • $5 * 15 = $75/share
  • Book Value Per Share = $30
  • $30 * 1.5 = $45/share
  • ($75 + $45) / 2 = $60/share

Results

Our Defensive Investor screen displays the top 25 stocks which meet all the “core criteria” in order of lowest price to intrinsic value (sorted top left to bottom right).

Implementation

Investors wanting to implement this screen would be wise to follow Graham’s advice on how to do so. Chapter 5 of The Intelligent Investor is titled “The Defensive Investor and Common Stocks.” In it, Graham states that a defensive investor strategy should entail “adequate though not excessive diversification.” He goes on to say this would mean a minimum of 10 stocks and a maximum of 30. This can be accomplished by periodically investing equal amounts in the qualifying stock with the lowest price in relation to intrinsic value.