For stock selection and for investing for defensive investors, Mr. Graham has mentioned a few criteria –
- Adequate size of the enterprise
Mr. Graham has quoted that investment candidate companies should not be too small into the size. As per him, we should not invest in the company which does not have sales and assets less than $100 Mn (Rs.700 crore) and $50 Mn (Rs.350 crore) respectively.
- A Sufficiently Strong Financial Condition
We should check the long-term debt to working capital also. Such strength provides a margin of safety to defensive investors.
- Earning stability
Earning of the company does not get highly fluctuated during the past ten years. This indicates that a company has a stable business model. The stability of the business model provides safety to defensive investors.
- Dividend record
Uninterrupted dividend for at least the last 20 years. Further, we can check that whether company paying dividend through cash earning or through debt, which I have already explained in – The Intelligent Investor 11
- Earnings growth
Earning should be grown for the last ten year. We should decide the % of earnings growth, we seek from the business.
- Moderate price/earnings ratio
As per Mr. Graham P/E ratio should not be higher than 15x for the past three years of average earnings. Reverse P/E ratio is near to the AAA bond rate, which means 1/15 = 6.67%.
- The moderate ratio of price to assets
The price to book value should not be higher than 1.5x. and also, P/E * P/BV will not be higher than 22.5x (15x * 1.5x). it can be possible that P/E can be 20x and P/BV can be 1.12x or vice-versa.
We should not invest in the companies where earnings getting worst though those companies are available at the cheaper valuation. And if everyone thinks similar for an investment opportunity then advantage for a similar investment opportunity will be gone. Similar happens during the FY17 to FY18 to equities where everyone wants to invest in the equities and equities valuation reach at the higher level.
Mr. Graham has also mentioned that we should not put all our eggs into the one basket, diversification protect us, minimize the risk. But diversification should help when we have a stock of quality companies, also over-diversification does not help. If we own the worst quality companies and make diversification then also our winning odds will never be favorable.
These all parameters are important for initial screening, after that we need to make our due diligence before investing in a particular stock. We need to read at least five years of annual reports, if the institution holds more than 60% to particular stock means that it is highly discovered (>15% is much more for Indian companies), and need to put efforts before investing.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig