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The Intelligent Investor (Chapter 14)

"Lower Risk" - Strategy/Minimum Effort - Defensive Grade Stocks

Benjamin Graham was an economist and professional investor who taught Warren Buffett, Irving Kahn, Walter J. Schloss and other famous investors at Columbia Business School.

Graham Formula (Defensive Investor)
The first grade of stocks recommended by Graham are called Defensive stocks. The criteria that Graham specified for identifying Defensive stocks are as following.

Summarised from Chapter 14 of The Intelligent Investor - Stock Selection for the Defensive Investor:
1. Not less than USD 100 million of annual sales.
[Note: This works out to USD 500 million as per the year 2007 based on the difference in CPI/Inflation from 1973]
2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past 10 years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past 10 years.
6. Current price should not be more than 15 times average earnings.
7. Current price should not be more than 1-1⁄2 times the book value.
As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

Graham's recommended price for Defensive stocks can be calculated from criteria #6 and #7 as the square root of (22.5 x EPS x BVPS). This price is popularly known as the Graham number - see Formula as stated above!

Buffett, who credits Graham with grounding him with a sound intellectual investment framework, describes Graham as the second most influential person in his life after his own father. In fact, Graham had such an overwhelming influence on his students that two of them, Buffett and Kahn, named their sons after him.

In the preface to Graham's book, The Intelligent Investor, Buffett calls it "by far the best book about investing ever written."

I just called this strategy "Lower Risk", since the Valuation figures should really serve as a cushion for finding stocks, which may be undervalued instead of highly overvalued - therefore implying an existing safety of margin when purchasing these stocks.

SOURCE: Short summary of "How to build a Benjamin Graham Portfolio"