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By Root 2692 0

8 we shall set forth our conviction that the bona fide investor does not lose money merely because the market price of his holdings declines; hence the fact that a decline may occur does not mean that he is running a true risk of loss. If a group of well-selected common-stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proved to be “safe.” During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer’s cost. If that fact makes the investment “risky,” it would then have to be called both risky and safe at the same time. This confusion may be avoided if we apply the concept of risk solely to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.2

Many common stocks do involve risks of such deterioration. But it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed “risky” merely because of the element of price fluctuation. But such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic-value standards—even if any subsequent severe market decline may be recouped many years later.

Note on the Category of “Large, Prominent, and Conservatively Financed Corporations”

The quoted phrase in our caption was used earlier in the chapter to describe the kind of common stocks to which defensive investors should limit their purchases—provided also that they had paid continuous dividends for a considerable number of years. A criterion based on adjectives is always ambiguous. Where is the dividing line for size, for prominence, and for conservatism of financial structure? On the last point we can suggest a specific standard that, though arbitrary, is in line with accepted thinking. An industrial company’s finances are not conservative unless the common stock (at book value) represents at least half of the total capitalization, including all bank debt.3 For a railroad or public utility the figure should be at least 30%.

The words “large” and “prominent” carry the notion of substantial size combined with a leading position in the industry. Such companies are often referred to as “primary”; all other common stocks are then called “secondary,” except that growth stocks are ordinarily placed in a separate class by those who buy them as such. To supply an element of concreteness here, let us suggest that to be “large” in present-day terms a company should have $50 million of assets or do $50 million of business.* Again to be “prominent” a company should rank among the first quarter or first third in size within its industry group.

It would be foolish, however, to insist upon such arbitrary criteria. They are offered merely as guides to those who may ask for guidance. But any rule which the investor may set for himself and which does no violence to the common-sense meanings of “large” and “prominent” should be acceptable. By the very nature of the case there must be a large group of companies that some will and others will not include among those suitable for defensive investment. There is no harm in such diversity of opinion and action. In fact, it has a salutary effect upon stock-market conditions, because it permits a gradual differentiation or transition between the categories of primary and secondary stock issues.

Commentary on Chapter 5

Human felicity is produc’d not so much by great Pieces of good Fortune that seldom happen, as by little Advantages that occur every day.

—Benjamin Franklin

The Best Defense is a Good Offense

After the stock-market bloodbath of the past few years, why would any defensive investor put a dime into stocks?

First, remember Graham’s insistence that how defensive you should be depends less on your