The fifth chapter of the Intelligent Investors is titled "The Defense Investor and Common Stocks". In this chapter Benjamin Graham lays the conservative foundation for picking defensive stocks. Mr. Graham suggests four rules to guide the investor to fill their portfolio.
I. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
II. 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.
III. Each company should have a long record of continuous dividend payments. To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950.
IV. 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.
When looking at a company in trying to decide whether it is the right investment for us we need to take a look at different aspects of the company. While no one set of rules is a guarantee to picker the right investment, it can certainly help us decide if we want to look further into the company or cut it loose.
We are going to look at Oracle (NYSE:ORCL) and run it through the above steps.
i. Oracle operates as a technology company. Oracle develops, manufactures and hosts software and hardware applications. Oracle also provides cloud based solutions and IT support. If you are looking for a technology company to add to our portfolio Oracle may be a good fit.
ii. Graham's conditions for being a conservatively financed company are just that, conservative. When applying how stringent Grahams parameters are, only a small hand full of companies are picked. The point of this is to ensure that the company we add to our portfolio has enough assets to avoid bankruptcy if the economy turns south.
In an attempt to simplify and save time we are going to look at total assets vs. liabilities. We are looking for at least twice as many assets as liabilities or 200%. As of the first quarter 2013 Oracle has $79,450,000 in assets and $35,660,000 in liabilities. The assets are 223% of liabilities.
iii. Graham wanted to see at least 20 years of paying consecutive dividends. Oracle has been consecutively paying a dividend for the last 4 years. Currently they have a payout ratio of 17%.
iv. A P/E of 20 at the current EPS of $2.15 is $43.00 a share. The earnings for the past seven years is as follows:
Based on an average EPS for the past seven years we get $1.21 a share and at a P/E of 25 we should not pay more than $30.14 a share.
Graham set some stringent guidelines when selecting stocks. When we look at the framework constructed by investing legends it is a good practice to take what they have developed and adjust it to fit our needs and goals. Graham set the foundation of value investing. The framework he developed is still a great way to look at stocks in today's market.
Simply because a stock does or does not pass a rule set up by someone else does not mean you should or should not start a position in it. In the case of Oracle, there are enough assets to prevent it from going bankrupt any time soon. Oracle has been paying out uninterrupted dividends for only 4 years with a current payout of 17%. With a low payout ratio, Oracle is most likely to continue paying out dividends in the future. Based on an EPS valuation Oracle is currently underpriced based on the past twelve months, but is overpriced based on the average of the past seven years.
It's up to the individual investor what investments are right for them. You can use all; any or none of Graham's teachings to help you decide what companies you wish to add to your portfolio. We're all trying to find that perfect stock that can help us build wealth and retire in comfort.
Disclosure: I am long KO, IBM, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.