Concept
Defensive Stock Criteria
Defensive stock criteria are Benjamin Graham's screening rules for investors who won't watch their holdings closely: buy only large, financially sound companies with long, unbroken records of earnings and dividends, at moderate prices, spread across many names.
Graham did not expect the defensive investor to value every company from scratch. In The Intelligent Investor he set out filters that do most of the screening for you. They answer three questions. First, will this company survive a bad decade? It should be a large firm, its current assets should be at least twice its current liabilities, and its long-term debt should be no greater than its net current assets. Second, has it earned through a bad decade? It should show positive earnings in each of the past ten years, dividends paid without a break for twenty, and per-share earnings up at least a third over the decade. Third, are you paying a sensible price for that proof? The price should be no more than 15 times average earnings of the last three years and no more than 1.5 times book value, or the two multiplied should stay below 22.5. Then hold 10 to 30 such companies. The aim is not the best stock. It is ruling out the ones most likely to hurt you.
A real-life example
Maya, a nurse, has a shortlist of six stocks for her retirement account. A fast-growing software firm fails twice: it lost money in three of the last ten years and trades at 45 times earnings. A regional bank pays dividends but cut them in 2009, so it fails too. A food maker with 30 years of dividends, steady profits and a P/E of 14 passes. She keeps the companies that pass, adds more until she holds fifteen, and stops hunting for a star.
How to use it
- 1Run each candidate through the survival test first: size, a current ratio of at least 2, and long-term debt below net current assets. Anything that fails is out, however good its story sounds.
- 2Check the record and the price next: ten years of positive earnings, twenty years of unbroken dividends, a one-third rise in earnings per share, a P/E under 15 on three-year average earnings, and a P/B under 1.5 (or the two multiplied under 22.5).
- 3Hold 10 to 30 passing companies across different industries. If maintaining the list feels like too much work, a low-cost index fund does the same job with less effort.