The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [49]
The argument we made for common stocks in 1949 turned on two main points. The first was that they had offered a considerable degree of protection against the erosion of the investor’s dollar caused by inflation, whereas bonds offered no protection at all. The second advantage of common stocks lay in their higher average return to investors over the years. This was produced both by an average dividend income exceeding the yield on good bonds and by an underlying tendency for market value to increase over the years in consequence of the reinvestment of undistributed profits.
While these two advantages have been of major importance—and have given common stocks a far better record than bonds over the long-term past—we have consistently warned that these benefits could be lost by the stock buyer if he pays too high a price for his shares. This was clearly the case in 1929, and it took 25 years for the market level to climb back to the ledge from which it had abysmally fallen in 1929–1932.* Since 1957 common stocks have once again, through their high prices, lost their traditional advantage in dividend yield over bond interest rates.† It remains to be seen whether the inflation factor and the economic-growth factor will make up in the future for this significantly adverse development.
It should be evident to the reader that we have no enthusiasm for common stocks in general at the 900 DJIA level of late 1971. For reasons already given* we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even if he must regard them as the lesser of two evils—the greater being the risks attached to an all-bond holding.
Rules for the Common-Stock Component
The selection of common stocks for the portfolio of the defensive investor should be a relatively simple matter. Here we would suggest four rules to be followed:
1. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.†
2. Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear. Observations on this point are added at the end of the chapter.
3. Each company should have a long record of continuous dividend payments. (All the issues in the Dow Jones Industrial Aver age met this dividend requirement in 1971.) To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.*
4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period. But such a restriction would eliminate nearly all the strongest and most popular companies from the portfolio. In particular, it would ban virtually the entire category of “growth stocks,” which have for some years past been the favorites of both speculators and institutional investors. We must give our reasons for proposing so drastic an exclusion.
Growth Stocks and the Defensive Investor
The term “growth stock” is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future. (Some authorities would say that a true growth stock should be expected at least to double its per-share earnings in ten years—i.e., to increase them at a compounded annual rate of over 7.1%.)† Obviously stocks of this kind are attractive to buy and to own,