10. Chapter 5: shares and the defensive investor
The investment advantages of shares are:
a. better protection against inflation than bonds, which offer little or no protection against inflation (Lyle’s note: because their yield is lower than shares?)
b. higher average return over the years (because they produce both dividend yield and also increase in market value).
These benefits can be lost if the investor pays too high a price for the shares.
10.1 Rules for the share component of the portfolio
a. adequate, but not excessive, diversification – total number of companies for which you hold shares should be between 10 and 30
b. each company for which you plan to hold shares should be large, prominent and conservatively financed (see section 10.7)
c. each company should have a long and continuous record of dividend payments (Graham: long = 20 years, Zweig: long = 10 years)
d. Price/Earnings ratio (P/E ratio) should not be too high
. price should be less than 25 x average earnings for the last 7 years, and
. price should be less than 20 x average earnings for the last 12 months (i.e. current P/E)
This is very strict. It rules out most “growth stocks”.
(Zweig: these two price formulas are roughly equivalent, but the first one lowers the odds that you’ll overvalue a share because of a temporary burst of profitability. See footnote p.159)
10.2 Growth stocks and the defensive investor
Even very big, very successful companies can still be “growth stocks”, with very large price and dividend fluctuations. Examples are IBM and Texas Instruments (Zweig: Microsoft and Cisco also).
The defensive investor should avoid growth stocks and concentrate on large companies which are relatively unpopular and therefore available at reasonable P/E’s.
10.3 Portfolio changes
Get your stockbroker to evaluate your portfolio at least once a year, and if adjustments are necessary, tell him to use the criteria in section 10.1 above. (Lyle’s note: Brewin Dolphin evaluate our portfolios twice a year, but I wonder if they use the criteria in section 10.1 above?)
10.4 Dollar-cost averaging
Very highly recommended (Lyle’s note: I wonder if there is a similar possibility in the UK, to buy a fixed value of shares every month).
10.5 The investor’s personal situation
Graham gives examples of a widow with a legacy, a doctor, and a young man in his first job (Lyle: I haven’t included the details), and suggests that the type of portfolio and the rate of return should not depend on the investor’s personal finances, instead it should depend on his “financial equipment” ( = knowledge, experience, skill, time available).
10.6 RISK
Downward price movements are not in themselves so bad, there’s no actual loss unless you sell the share at a lower price than you bought it, of course.
10.7 Note on “conservative” companies
Rule (b) in section 10.1 above says: “each company for which you plan to hold shares should be large, prominent and conservatively financed”. The accepted definition for conservative is that the value of the shares should represent at least half of the total capitalisation.
10.8 Zweig on Chapter 5
Zweig quotes a Turkish proverb that “After you burn your mouth on hot milk, you start to even blow on your yogurt to cool it” (Lyle: I checked. This is a genuine Turkish proverb).
A lot of people got burned in 2000-2001, and more have got burned in 2007-2011, but although the there are other alternatives that are less risky than shares, their returns are not very attractive.
11. Chapter 6, enterprising investor: negative approach to portfolio policy
The starting point for the enterprising investor is the same as for the defensive investor: some mixture of bonds and leading companies’ shares.
After this starting point, where do differences in portfolio policy for the defensive investor and the
enterprising investor appear? The main differences are negative:
. don’t invest in preferred shares, leave that work to the investment funds and corporate buyers.
. avoid junk bonds, convertible bonds and foreign bonds. (Foreign bond funds can be used as a hedge, but they shouldn’t be more than 10% of the total bond value in the portfolio, and don’t buy them if they charge annual operating expenses of more than 1.25%, and be careful that they don’t charge “short-term redemption fees” if you sell again too soon after you buy them).
. avoid new issues (IPO’s), especially in bull markets
. avoid shares whose excellent earnings are only recent.
Avoid “day-trading”, it’s financial suicide.
12. Chapter 7, enterprising investor: positive approach to portfolio policy
The main points:
a. buying low, selling high
b. buying carefully selected growth stocks
c. buying carefully selected bargain issues
d. buying into “special situations”.
12.1 Timing
The best starting points are either the 50-50 bond/share mix or the 75-25 bond/share mix. See also Chapter 8.
Although “buy low, sell high” is clearly a common-sense approach, it is very difficult to time your sales for the time when a rising market (bull market) has reached its peak, and very difficult to time your buying for the time when a falling market (bear market) has reached its bottom.
(Zweig: forget about timing, it’s impossible).
12.2 Growth shares
Drawbacks:
a. price may be too high
b. the growth that you expect may not happen
There are “growth stock funds” available, but they don’t perform better than blue-chip funds, so if these professionals can’t outperform, how can the amateur?
12.3 Bargain issues and special situations
Only for experts.
12.4 Three recommended areas for the enterprising investor
To do better than average in the long-term, a policy must:
a. meet objective, rational tests of soundness
b. differ from the policy of most investors
He suggests 3 very different policies that are like this, but only one is easy to understand: buying the shares of relatively unpopular large companies.
12.4 Relatively unpopular large companies
Companies become unpopular on the stock market for various reasons, e.g. they get into financial difficulties. Shares in relatively unpopular small companies should be avoided because companies like that often go bankrupt if they get into difficulties.
On the other hand, big companies which get into difficulties have big advantages over small companies in this type of situation, they have the resources and the brain power that they need to tide them over, and the market is likely to reward any improvement in their situation fairly quickly.
Indicator of unpopularity: low P/E ratio (price/earnings ratio)
This is called “The Dogs of the Dow” approach. See end of p. 165 in the book.
The investment advantages of shares are:
a. better protection against inflation than bonds, which offer little or no protection against inflation (Lyle’s note: because their yield is lower than shares?)
b. higher average return over the years (because they produce both dividend yield and also increase in market value).
These benefits can be lost if the investor pays too high a price for the shares.
10.1 Rules for the share component of the portfolio
a. adequate, but not excessive, diversification – total number of companies for which you hold shares should be between 10 and 30
b. each company for which you plan to hold shares should be large, prominent and conservatively financed (see section 10.7)
c. each company should have a long and continuous record of dividend payments (Graham: long = 20 years, Zweig: long = 10 years)
d. Price/Earnings ratio (P/E ratio) should not be too high
. price should be less than 25 x average earnings for the last 7 years, and
. price should be less than 20 x average earnings for the last 12 months (i.e. current P/E)
This is very strict. It rules out most “growth stocks”.
(Zweig: these two price formulas are roughly equivalent, but the first one lowers the odds that you’ll overvalue a share because of a temporary burst of profitability. See footnote p.159)
10.2 Growth stocks and the defensive investor
Even very big, very successful companies can still be “growth stocks”, with very large price and dividend fluctuations. Examples are IBM and Texas Instruments (Zweig: Microsoft and Cisco also).
The defensive investor should avoid growth stocks and concentrate on large companies which are relatively unpopular and therefore available at reasonable P/E’s.
10.3 Portfolio changes
Get your stockbroker to evaluate your portfolio at least once a year, and if adjustments are necessary, tell him to use the criteria in section 10.1 above. (Lyle’s note: Brewin Dolphin evaluate our portfolios twice a year, but I wonder if they use the criteria in section 10.1 above?)
10.4 Dollar-cost averaging
Very highly recommended (Lyle’s note: I wonder if there is a similar possibility in the UK, to buy a fixed value of shares every month).
10.5 The investor’s personal situation
Graham gives examples of a widow with a legacy, a doctor, and a young man in his first job (Lyle: I haven’t included the details), and suggests that the type of portfolio and the rate of return should not depend on the investor’s personal finances, instead it should depend on his “financial equipment” ( = knowledge, experience, skill, time available).
10.6 RISK
Downward price movements are not in themselves so bad, there’s no actual loss unless you sell the share at a lower price than you bought it, of course.
10.7 Note on “conservative” companies
Rule (b) in section 10.1 above says: “each company for which you plan to hold shares should be large, prominent and conservatively financed”. The accepted definition for conservative is that the value of the shares should represent at least half of the total capitalisation.
10.8 Zweig on Chapter 5
Zweig quotes a Turkish proverb that “After you burn your mouth on hot milk, you start to even blow on your yogurt to cool it” (Lyle: I checked. This is a genuine Turkish proverb).
A lot of people got burned in 2000-2001, and more have got burned in 2007-2011, but although the there are other alternatives that are less risky than shares, their returns are not very attractive.
11. Chapter 6, enterprising investor: negative approach to portfolio policy
The starting point for the enterprising investor is the same as for the defensive investor: some mixture of bonds and leading companies’ shares.
After this starting point, where do differences in portfolio policy for the defensive investor and the
enterprising investor appear? The main differences are negative:
. don’t invest in preferred shares, leave that work to the investment funds and corporate buyers.
. avoid junk bonds, convertible bonds and foreign bonds. (Foreign bond funds can be used as a hedge, but they shouldn’t be more than 10% of the total bond value in the portfolio, and don’t buy them if they charge annual operating expenses of more than 1.25%, and be careful that they don’t charge “short-term redemption fees” if you sell again too soon after you buy them).
. avoid new issues (IPO’s), especially in bull markets
. avoid shares whose excellent earnings are only recent.
Avoid “day-trading”, it’s financial suicide.
12. Chapter 7, enterprising investor: positive approach to portfolio policy
The main points:
a. buying low, selling high
b. buying carefully selected growth stocks
c. buying carefully selected bargain issues
d. buying into “special situations”.
12.1 Timing
The best starting points are either the 50-50 bond/share mix or the 75-25 bond/share mix. See also Chapter 8.
Although “buy low, sell high” is clearly a common-sense approach, it is very difficult to time your sales for the time when a rising market (bull market) has reached its peak, and very difficult to time your buying for the time when a falling market (bear market) has reached its bottom.
(Zweig: forget about timing, it’s impossible).
12.2 Growth shares
Drawbacks:
a. price may be too high
b. the growth that you expect may not happen
There are “growth stock funds” available, but they don’t perform better than blue-chip funds, so if these professionals can’t outperform, how can the amateur?
12.3 Bargain issues and special situations
Only for experts.
12.4 Three recommended areas for the enterprising investor
To do better than average in the long-term, a policy must:
a. meet objective, rational tests of soundness
b. differ from the policy of most investors
He suggests 3 very different policies that are like this, but only one is easy to understand: buying the shares of relatively unpopular large companies.
12.4 Relatively unpopular large companies
Companies become unpopular on the stock market for various reasons, e.g. they get into financial difficulties. Shares in relatively unpopular small companies should be avoided because companies like that often go bankrupt if they get into difficulties.
On the other hand, big companies which get into difficulties have big advantages over small companies in this type of situation, they have the resources and the brain power that they need to tide them over, and the market is likely to reward any improvement in their situation fairly quickly.
Indicator of unpopularity: low P/E ratio (price/earnings ratio)
This is called “The Dogs of the Dow” approach. See end of p. 165 in the book.