Benjamin Graham's chapter titled "The Defensive Investor" in his classic work "The Intelligent Investor" provides much food for thought on conservative portfolio construction. Graham built his reputation by focusing on the "margin of safety" concept, and he flushed it out when he explained his four rules that should guide the investor's selection of common stocks. I have included his four rules in bold below, followed by my commentary on how they might affect your own portfolio decisions in today's market.
1. Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.
When we're dealing with small and mid-cap companies, the rationale for avoiding the ones that carry a high debt load is clear: an unexpected drop in profits over a 3-5 year stretch could easily bring the company into bankruptcy. That is not the risk so much with large, prominent blue-chip stocks. Sure, Procter & Gamble's (NYSE:PG) $32 billion debt load may be larger than some investors would like to see, but there is no serious risk of bankruptcy. After all, even with Colgate-Palmolive (NYSE:CL) and Kimberly-Clark (NYSE:KMB) gobbling up some of Procter & Gamble's market share, the company still only experienced a modest earnings decline from $3.93 in 2011 to $3.85 in 2012. This is the benefit of being a shareholder in a company that has over two dozen $1 billion brands as is the case with Procter & Gamble.
Rather, the reason why it makes sense to find the conservatively financed blue-chips is not merely because it adds a margin of safety against bankruptcy. For me, I dislike companies carrying large debt loads because the money that could be used for buybacks, dividends, and organic growth is instead used to pay off the actions of the company's past. A perfect example of this would be something like Anheuser-Busch (NYSE:BUD). The company has $41 billion in debt partly because Inbev needed to issue debt to acquire the legendary St. Louis brewer in 2008.
Obviously, Anheuser Busch has very reliable cash flow, and is nowhere near posing a bankruptcy risk. But when you have $40 billion in debt on your balance sheets, you have added a substantial hurdle in creating future value because a meaningful portion of the profits that could fund growth, dividends, or buybacks must instead go towards debt servicing. This is a strong contrast to a company like Berkshire Hathaway (NYSE:BRK.B), which has over $1 billion coming through the doors each month that can be used for acquisitions, investments or buybacks.
2. Each company should have a long record of continuous dividend payments.
In the commentary for this rule, Jason Zweig notes that "insisting on 20 years of uninterrupted dividend payments would not be overly restrictive." Graham's relationship with dividends is something that should properly be understood by noting the context of early 20th century investing in the United States. In Graham's day, trading costs were high. You had to buy in round lots of 100 shares. You might be lucky to get a few updates directly from the company per year, plus whatever you read in The Wall Street Journal. Effectively, you had no choice but to be a long-term investor. And if you're wedded to owning an asset for 10+ years, you're going to choose your investments carefully and want regular income to provide regular gratification for your ownership.
Graham was well aware that individuals arranged their personal financial lives and budgets around dividend income, interest from savings accounts (yes, that was once a source of income!) and rents. Therefore, it was of the utmost importance that investors buy shares of companies that have proven to be a stable source of income for investors throughout the "normal vicissitudes of the business cycle," which two decades of dividends can prove. I think of conservative investing as the art of trying to stack the deck in my favor to the best extent possible. Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) have upped their payouts to shareholders every year since 1963. Sure, this streak could end, and it is my job as an investor to monitor for signals that the business is deteriorating. But if I am going to fail as an investor, I want it to be because a bunch of half-century dividend streaks are coming to an end.
3. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
Graham often regarded portfolio construction as an investor's pursuit of creating his own insurance company. Sure, there are some "policies" that might go bad along the way, but if you could own two dozen blue-chip stocks gushing out increasing streams of income each year, then you can still march towards your goals even if you make a few bad decisions along the way (note: I am speaking on my own behalf when I mention the part about growing streams of income. Graham did not focus his writings on the dividend growth, but rather, stated that an investment should be considered if the present income provided turned out to be adequate). An investor that happened to own Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), or JPMorgan (NYSE:JPM) during the banking crisis would have survived (and perhaps even improved his annual income) if he held thirty stocks. If he only held ten companies, he would have been in trouble.
Whether you choose to tilt towards the "ten" or "thirty" number is an individual decision that depends on your personal circumstances. When Charlie Munger ran his partnership, he would put over 70% of the total assets in 4-6 securities. When Graham ran the Graham-Newman partnership, he would buy anything he could find that was trading at a substantial enough discount to intrinsic value. Both approaches can work quite well.
Although I will add this: Munger had plenty of assets (such as real estate and oil partnerships) humming along in the background generating profits, and this no doubt makes it easier to run a focused portfolio. If you have a pension or own real estate, a ten stock portfolio may not be dangerous. But if you intend to only rely on common stock income to fund your lifestyle, it makes a lot more sense to be conservative and lean towards thirty (because, presumably, the risk of loss is of greater concern than the pursuit of gain).
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.
This is the limit many blue-chip investors are testing now. I would guess that the investors of excellent companies like Kellogg (NYSE:K), Brown-Forman (NYSE:BF.B), and Hershey (NYSE:HSY) will experience total returns over the next 5-10 years that lag their actual earnings growth. Kellogg is at over 20x earnings, Brown-Forman 25x earnings, and Hershey is approaching 30x earnings. Those are, in escalating degrees, well above the historical P/E ratios of each company. Graham kept it simple: he advised staying away from these securities altogether.
The implicit theory is that, once you cross the 20x earnings threshold when buying a stock, you need to rely on high growth (and perhaps a bit of luck) to generate satisfactory returns over the subsequent decade. Considering that Graham built his entire teaching reputation around the "margin of safety" concept, it makes sense that he would not advocate paying a premium price because investors could experience mediocre returns if the high growth did not materialize (and Graham did not like the speculative nature of relying on high growth in order to succeed).
Benjamin Graham's advice on conservative stock picking teaches us that the best way to predict the future is by sizing up the present and keeping in mind the past. If you apply each of Graham's elements to your own portfolio, the risk of loss becomes incredibly small. Graham encourages us to look at the past by only considering companies with long, uninterrupted dividend streaks. From there, he wants you to make sure they are (1) large, (2) prominent, and (3) conservatively capitalized in the present moment. But of course, identifying the excellent company is not enough, and Graham points out that it is hard to go wrong if you never pay more than 20x earnings for such a company. And to wrap it all up, Graham encouraged us to own 10-30 companies that meet these conditions. If you seek to follow an investing style that incorporates a margin of safety, it seems that Mr. Graham has given us one heck of a blueprint.