Chapter 4: General Portfolio Policy – The Defensive Investor
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“When you leave it to chance, then all of a sudden you don’t have any more luck.”
– Pat Riley
- Investor risk appetite ranges from that of the conservative savings bank, life-insurance company or legal trust fund to that of the experienced business person willing to include any kind of bond, stock (or other asset) in their security list provided they feel it is an attractive purchase
- The rate of return sought should be proportional to the amount of intelligent effort the investor is willing to take on (not the amount of risk they are willing to take on or the number of investing years they have remaining). There are two ways to be an intelligent investor:
- Continuously research, select and monitor a dynamic mix of stocks, bonds & mutual funds = Enterprising Investor
- Create a permanent portfolio that runs on autopilot and requires no further effort = Defensive Investor
- One can also create a hybrid portfolio with a partially active & partially passive component
- The simple proportion allocation suggested by Graham (50/50 between bonds & stocks which can be adjusted 25% in either direction based on the goals, beliefs and time available to the particular investor “restrain(s) [the investor] from being drawn more and more heavily into common stocks as the market rises to more and more dangerous highs”
- An investor can increase the allocation towards common stocks above 50% when bargain price levels exist & decrease the portion below 50% when the market level is judged to be dangerously high (To do so, the investor should create their own formulaic “buying point,” Graham suggests the ratio of dividend yield to bond yield as one metric to track). However this assessment can be difficult to follow (most are liable to increase their holdings in common stock when they see the market rising quickly not decrease their holdings) so for the defensive investor a fixed proportion likely makes more sense. A minimum of 25% in Bonds (or Cash) gives an investor the fortitude to stick to the strategy (and even buy more common stock) when the market is falling
- Taxable vs Tax Free (Municipal) Bonds
- This question depends on the delta in yield as well as the investors tax bracket. For example in 1972:
- 20 Year AA Corporate Bond = 7.5%
- 20 Year “Municipal” (term is generally used to describe all tax exempt bonds including state obligations) Bond = 5.3%
- Difference is ~30% loss moving from corporate to municipal bond. If investor’s maximum tax rate was more than 30% they would have a net saving investing in Municipals
- Unless in a lower tax bracket, it is best to buy taxable bonds only within a tax advantaged (sheltered) account such as a 401K or Roth IRA
- This question depends on the delta in yield as well as the investors tax bracket. For example in 1972:
- “It is interesting to note… that in many cases the indirect obligations of the U.S. government yield appreciably more than its direct obligations of the same maturity.” This is because of debt limitations on government borrowing by congress (guarantees by the government are for some reason not regarded as debts).
- Short-term vs Long-term Bonds:
- The face value of a Bond & interest rates are inversely related
- That is if interest rates rise, bond prices fall. The effect is more pronounced in long term bonds
- Most defensive investors would be best served by purchasing intermediate bonds so as to avoid the guessing game around interest rate movement
- Types of Bonds
- US Savings Bonds – Not marketable (cannot sell to another investor). Come in denominations as low as $25 making a good gift for children or grandchildren
- Other US Bonds (Treasuries)
- State and Municipal Bonds (exempt from federal tax – generally exempt from state income tax in the state they are issued)
- Are either a direct obligation of the state or subdivision or revenue bond dependent for interest payments on receipts from a toll road, bridge, building lease etc
- Corporation Bonds
- Are either “straight,” non-convertible bonds or convertible bonds (warrants attached) to common stock. Typically offer a yield in line with the companies credit risk
- Income Bonds – Interest not paid unless earned by the company
- Bond Funds – allow for greater diversity & a lower investment hurtle (individual bonds are generally sold in $10,000 lots)
- Other fixed income instruments
- Mortgage Backed Securities (MBS) – Thousands of mortgages pooled together with the income stream sold off to investors
- Annuities – insurance like investment
- Bond Call Provisions
- Be careful of bonds that are callable soon after issuance. This feature allows bond issuers to redeem the bond before its specified maturity date (generally done if conditions have turned more favorable for the issuer such as a decline in market interest rates). Graham calls this, “heads I win, tails you lose,” and recommends the intelligent investor sacrifice a small amount of yield to obtain the assurance of non call-ability. Similarly he recommends buying a low coupon (coupon = interest rate) bond at a discount over a high coupon bond selling at par that is callable
- Straight (Non-convertible) Preferred Stocks – Dependent on the ability and desire of a company to continue paying dividends on its common stock. If common stock dividends are in danger then the non-convertible preferred stock is precarious (company is under no obligation to pay dividend unless it is payed to common stock holders & the holder of preferred stock does not share in any profits beyond the fixed dividend rate. “Really good preferred stocks can and do exist but they are good in spite of their investment for, which is an inherently bad one.”
- Time to buy preferred stock is when “price is unduly depressed by temporary adversity,” and is only appropriate for the enterprising investor
Chapter 5: The Defensive Investor & Common Stocks
“Human felicity is produc’d not so much by great Pieces of good Fortune that seldem happen, as by little Advantages that occur every day.” – Benjamin Franklin
- Investment Merits of Common Stocks
- Stocks offer a considerable degree of protection against the erosion of the investors dollar by inflation, bonds offer no such protection
- This does not mean stocks are worth buying at any price. It took 25 years for stocks to regain their 1929 highs
- Stocks generally outpace the returns of bonds over the long term
- But not always. At the beginning of 1949 the annual return of stocks over the previous 20 years was 3.1% vs 3.9% for bonds
- Paradoxically, after a market crash the public generally views stocks as risky while the very act of crashing has removed much of the risk
- “When stocks are priced reasonably enough to give you future growth, then you should own them, regardless of the losses they may have cost you in the recent past.”
- “At recent prices, bonds offer such low yields that an investor who buys them for their supposed safety is like a smoker who thinks he can protect himself against lung cancer by smoking low-tar cigarettes.”
- Stocks offer a considerable degree of protection against the erosion of the investors dollar by inflation, bonds offer no such protection
- Rules for the Common Stock Component:
- Adequate but NOT excessive diversification. 10-30 issues recommended
- Each company selected should be large, prominent and conservatively financed:
- Leading position in its industry
- Market capitalization of at least $10 Billion
- Common stock at book value (Total Assets – Liabilities – Preferred Stock) should represent less than 50% of total capitalization (debt + equity), including all bank debt. In other words the company should have an Loan To Value (LTV) ratio of less than 50% (to compare to real estate investing).
- Each company should have a long record of continuous dividend payments
- Set a max earnings multiple you are willing to pay (i.e no more than 25x average earnings over the last 7 years and no more than 20x the last 12 months earnings). This will exclude most growth stocks
- A “Growth Stock,” is a stock that has increased its per share earnings in the past at well above the average rate and is expected to continue this trend (some argue a growth stock should double its per share earnings over 10 years = 7.1% annual growth or greater)
- Rule of 72 – To estimate the length of time for a value to double, divide its assumed growth rate into 72. At 6% it will take 12 years to double (72/6 = 12)
- Growth stocks tend to see stock price grow at a faster rate than earnings before falling back in line. The hotter they are, the harder they fall
- Graham instead suggests, “large companies that are relatively unpopular, and therefor obtainable at reasonable earnings multipliers”
- Dollar Cost Averaging: Under this plan, the investor makes purchases of the same dollar amount in regular intervals. Over a long period of time this smooths out the fluctuations of a stock & allows an investor to purchase with more confidence and probability of positive returns
- More income does not give someone a greater chance at succeeding as an enterprising investor. In fact a demanding career may inhibit the ability of the investor to spend sufficient time researching & selecting stocks
- “Finance has a fascination for many bright young people with limited means. They would like to be both intelligent and enterprising in the placement of their savings, even though investment income is much less important to them than their salaries”
- It is typical to hear the risk of financial securities ordered as follows: Bonds > Preferred Stock > Common Stock. However Graham says the true measure of risk should be:
- Does the instrument pay the expected rate of return (for common stock is the dividend payed as expected)
- Is there a high chance that the holder may have to sell at a time when the price is well below the cost
- NOT is there a chance that the price will decline temporarily due to cyclical forces. An investor does not lose money merely because the market price of his holdings declines
- Buy What You Know Theory:
- Popularized by Peter Lynch, the theory goes that amateur investors can have the advantage of “common knowledge,” over professional investors. i.e, You discover a great new product or notice a business who’s parking lot is always full. However finding a promising company is only the first step. You must then do the research. “No one should ever invest in a company, no matter how great its products or how crowded the parking lot, without studying its financial statements.”
- This rule is taken too far by investors . Most 401K investors hold 25-30% of their retirement assets in the stock of their own company
- “Becoming more familiar with subject does not significantly reduce people’s tendency to exaggerate how much they actually know about it”