Chapter 5 Defensive Investors and Ordinary Shares

 Benefits of investing in common Shares

in our first edition (1949) we felt it necessary to discuss at length the point that large ordinary share components should be included in all investment portfolios.' Ordinary shares are generally regarded as highly speculative, and therefore unsafe. They had fallen well below their 1946 high, but rather than attracting investors to their reasonable prices, the fall eroded fundamental confidence in equity securities. We have commented on the opposite developing over the following 20 years, during which the large rise in share prices to record high levels presented them as a safe and profitable investment, which could potentially also entail considerable risk.

The argument we made in 1949 in favour of ordinary shares highlights two important points. First, they offer a good degree of protection against the erosion of every penny of the investor's wealth by inflation, whereas bonds offer no protection. The second advantage of ordinary shares is the high average return the investor receives over a period of years. This is achieved in two ways. The average dividend yield is higher than the yield on good bonds and the reinvestment of undistributed profits results in a rise in market value over the years relative to the underlying trend.While these two advantages are very important and have led to ordinary shares outperforming bonds over the long term, we have always cautioned that shareholders may miss out on these advantages if they buy shares at too high a price. This was the case in 1929, and it took 25 years for the market to recover to the level from which it had fallen sharply during the 1929-1932 period. Since 1957 ordinary shares have again, because of their high prices, lost the traditional advantage of dividend yields over bond interest rates. It remains to be seen whether Whether inflation and economic growth factors offset this major adverse development in the future.It will be obvious to readers that we were not generally overly bullish on common stocks at the 100 DJIA level in late 1971. For the reasons already given, we feel it is important for a defensive investor to have a reasonable proportion of common stocks in his portfolio. Even if he views them as the lesser of evils, the greater risk is in all-bond holdings.

Rules for Ordinary-Sheaver Components

 the selection of ordinary shares for the portfolio of aggressive investors should be relatively simple in nature. Here we list four rules to be followed:.)

1. Diversification should not be too much, but it should be adequate. This means ten different stocks, up to a maximum of about thirty.
2. Each company selected must be fairly large, prominent, and conservatively funded. These characteristics, while vague, are generally obvious. Notes on this point are provided at the end of the chapter.
3. Each company must have a long track record of consistent dividend payments. (All stocks in the Dow Jones Industrial Average have met this dividend requirement on average since 1971.)
4. To make this point clearer we suggest the need for constant dividend payments in the early 1950s.4. An investor should fix a limit for himself on the price he is willing to pay for an issue, which is in line with the issue's average earnings, say, over the last seven months. We recommend a limit of 25 times such average earnings, not exceeding 20 times over the last twelve-month period. But such a limit would exclude almost all stocks of strong and popular companies from portfolios. In particular, it would virtually exclude the entire class of 'growth stocks', which would have been the darling of all speculators and institutional investors over the past few years. We have reasons for proposing such a strict prohibition.

Growth Stocks and Defensive Investors

the term 'growth stock' is applied to those which have had earnings per share that are generally larger than those of ordinary shares in the past and are expected to continue to grow in the future. (Some authorities say that a true 'growth stock' should be expected to at least double its earnings per share in ten years, i.e. grow at a compound annual rate of more than 7.1%). Obviously, such stocks are attractive to buy and own, provided that their price is not excessive. This is the problem, and it is because growth stocks sell for many times higher than their current and past average earnings. This adds weight to the speculative element in the case of growth stocks and makes it untenable to operate in this sector.

International Business Machines has long been a leading growth stock issue and has produced extraordinary returns for those who have owned it for years and who have held on to it, but we would also point out that this one of the 'best ordinary stocks' lost 50% of its value in six months during the 1961-62 crash and lost almost as much market value during 1969-70. Other growth stocks have been even more vulnerable to the bad conditions. In some cases not only did the price go down, but their earnings also fell, doubling down the woes of their holders. Another good example for us is Texas Instruments, which rose from 5 to 256 in six years. That too without paying a dividend, while its earnings rose from 40 cents to $3.91 per share. (Statement. That the profit grew five times faster than the price. This is a characteristic of popular ordinary shares), but after two years the income fell by about 50% and the price by one-fifth.These events can explain why we consider Groch stocks to be overall uncertain and a risk for defensive investors. Of course,At the right level, making the right individual picks and then selling them at a gain before a potential downturn can work wonders, but for the average investor, hoping for this is like planting a money tree. In contrast, we believe that a group of large companies that are relatively unpopular, and therefore can be leveraged at reasonable earnings multiples, is a solid but simple way of choosing for the general public. We will expand on this idea in our chapter on portfolio planning.

portfolio Change

it is now standard practice to periodically examine all securities to see if there is scope for quality improvement. Of course, this is a key part of the service offered by investment advisers to clients. Almost all brokerage houses are willing to provide such advice, without charging a separate fee, as it is a commission. Some brokerage houses offer investment management services free of charge.All our defensive investors should do is seek—at least once a year, if possible—the same advice on changes to their portfolios that they took when they invested. Since he himself is not very good at choosing trustworthy things, he should make sure that he relies on firms with very good reputations; otherwise, he will easily fall into inefficient and unethical hands. In any case, it is important to reiterate in every conversation with your adviser the desire to follow carefully the four rules for the selection of common-shares, described earlier in this chapter. Incidentally, if the list is competently chosen in the first place, there is no need for frequent or numerous changes.

Dollar-Cost Averaging

the New York Stock Exchange has expended great effort in popularizing its 'monthly purchase plan,' under which an investor may devote the same amount of money to purchasing one or more common shares each month. This is a special type of formula investing known as dollar-cost averaging. During the mainly rising-market experience since 1949, such procedures have had highly satisfactory results, especially as they prevent the investor from buying at the wrong time.In a comprehensive study of Lucille Tomlinson's Formula Investing Plan 1, the author presents the results of dollar-cost averaging for a group of stocks included in the Dow Jones Industrial Average. The test involved 23 ten-year buying periods.

23 purchase periods were included, the first ending in 1929 and the last in 1952. Each test showed a profit, whether it occurred at the end of the purchase period or five years later. The average indicated profit at the end of these 23 purchase periods was 21.3%, not including dividends received. Needless to say, in some instances the market price temporarily declined significantly. Ms. Tomlinson concludes her discussion of this very simple investment formula with this remarkable statement: No one has ever invented an investment formula as simple as dollar cost averaging, which can be used with such confidence as to ensure optimum success, regardless of the price of securities.It may be objected that the dollar cost averaging principle, as simple as it sounds, is unrealistic in practice, since few people are so stable as to invest the same amount in common shares each year for, say, 20 years. I think that this apparent objection has weakened in recent years. Common shares have become generally accepted as an essential component of a good savings investment program. Thus, systematic and consistent purchases of common shares may present no more psychological and financial difficulties than similar constant payments for United States Savings Bonds and life insurance, to which they must be supplemented. The monthly amounts may be small, but the results after 20 years or more can be very impressive and valuable to the saver.

Investor's own Position

at the beginning of this chapter we briefly described the situation of a single portfolio owner. Let's revisit it in light of the upcoming discussion of our general strategy. What level of security type should an investor choose based on his circumstances? As concrete examples illustrate different situations, our examples are (1) a widow with $200,000 to support herself and her children; (2) a successful doctor in the middle of his career with $100,000 in savings and an annual increase of $10,000; and (3) a punter who earns $200 a week and saves $1,000 a year."

For the widow, living on this income is a big problem. On the other hand, it is necessary to be conservative in her investments. The division of her capital equally between United States bonds and first-grade ordinary shares is a compromise of these objectives and in keeping with our general concept of a defensive investor. (The maximum share of shares can be 75%, if the investor is mentally prepared for this decision, and if she is more or less sure that she will not buy it at too high a price. Which, of course, was not possible in early 1972.We do not consider it likely that the widow qualifies as an enterprising investor, because if she did, her motives and methods would be quite different. One thing the widow should not do is speculate in order to obtain large additional income. What we mean by this is to try to obtain profit and higher income without having the necessary means to have full confidence in success. It would be better for her to continue withdrawing $2000 a year from her original capital to cover all her expenses than to invest half of the money in speculative ventures that are on shaky ground.The wealthy doctor is not under the same pressures and compulsions as the widow, yet we believe his choices should be similar. Is he willing to take a serious interest in investing? If he does not have such a passion or temperament, he is better off accepting the comfortable role of a defensive investor. His portfolio division should not be very different from that of the 'typical' widow, and his personal preferences in deciding the size of the share component should be similar to those in the sector. Annual savings should also be invested in proportion to the full fund.The doctor is more likely than the widow to become an entrepreneurial investor, and probably be more successful at it, although one thing he is lacking is the fact that he has signs of getting an investment education and learning to manage his own money.Time will be short. Medical professionals are notoriously unsuccessful in their securities trading. This is because they have sufficient confidence in their intelligence and a strong desire to get a return on their investments, but without realizing that to do so successfully requires both great attention and a professional approach to security pricing.Finally, the young man who saves $51,000 a year and wants to gradually improve further has the same option as his friend. Some of his savings should automatically go into Series E bonds. The balance will then be so small that he can hardly afford to do so without the rigorous education and discipline of an aggressive director.

So our standard program for a charioteer is to adopt the simplest and most logical policy.Here we should not ignore human nature. Finance is a very tempting topic for many talented young people with limited means. They want to be both smart and entrepreneurial in investing their savings, even if the investment income is much less than their salary. This approach is very good. It is very beneficial for the young investor to start his financial education and gain experience early. If he acts as an aggressive investor, he is bound to make mistakes and suffer huge losses. Young people have managed to handle these disappointments and profits. We urge beginners in securities not to waste their hard work and money trying to beat the market. First study security prices and test your decisions on profit versus value by investing very small amounts of money in the beginning.Thus, we come back to our statement made in the beginning that the type of securities to buy and what rate of return to expect does not depend on the financial resources of the investor but on his financial tools such as his knowledge, experience and temperament.

concept of Risk

it is traditional to say that good stocks are less risky than good preferred stocks and good preferred stocks are less risky than good common stocks. This has led to the narrative against common stocks that they are not 'safe', as was the position of the Federal Reserve Board in 1948. We want to make it clear here that the terms 'risk' and 'safety' apply to securities in two ways, resulting in a difference.A bond clearly becomes unsafe when it cannot provide space or capital. Similarly, if a preferred stock or common stock is purchased with the expectation that it will continue to pay a fixed dividend return, and then the dividend is not received, it proves unsafe. It is also true that an investment is at risk even when there is a good chance that the holder will have to sell it when its price falls below the original purchase price.However, the risk consideration extends to a fall in the price of the underlying security, even if the fall is of an intended or temporary nature and even if there is no pressure on This rule is more common in ordinary shares than in United States savings bonds, and in most other high-grade issues, but we believe that this is not a real risk in the useful sense. A person who has mortgaged a building and has to sell it at an inopportune time will suffer a substantial loss. This factor is not taken into account in measuring security and risk in ordinary real estate mortgages. Then the only measure is punctual payment. Similarly, the measure of risk in any ordinary commercial business is the loss of money, not what will happen if the owner is forced to sell.In Chapter 8 we will expand on our argument that a bona fide investor does not lose money simply because the market value of his holdings is falling, because the fact that it is falling does not mean that he is actually at risk of loss. If a well-selected portfolio of ordinary shares is generating satisfactory returns, over a period of years, an investment in this portfolio will be considered 'safe'. During this period its market value is bound to fluctuate, and it may or may not sell for less than its purchase price for some time. If this fact makes an investment 'risky', it must be called both risky and safe at the same time. This problem can be avoided if we apply the concept of risk only to a fall in value caused by a decision to sell or a significant deterioration in the company's fortunes, or, as is often the case, by paying more for the security than it is actually worth.Many ordinary shares are not at risk of such a decline, but we believe that a properly executed investment in a block of ordinary shares does not carry such a significant risk and should not therefore be viewed as 'risky' simply because there is an element of price volatility. Such risk would exist only if there was a risk that the price might prove to be clearly excessive by the standards of intrinsic value - even if any serious market declines would then take many years to compensate for.Large, dominant, and conservative funded corporate classThe phrase in our title was used earlier in this chapter to describe the types of simple shapers to which a defensive investor might limit his purchases provided they pay dividends for a number of years in a row. Scales based on adjectives are often ambiguous. These include size, prominence, and What is the dividing line of liberality of financial donations? Now we will suggest a standard scale, which is fairly discretionary but free of cost. The finances of an industrial company cannot be proprietary unless the ordinary shares represent at least 30% of the total capital (including bank loans) at book value. For a railroad or public utility it should be at least 30%.The terms 'large' and 'major' carry the connotation of strong size as well as dominant position in an industry. Such companies are often referred to as grim reapers, and all other ordinary shares are referred to as 'secondary', as buyers of market stocks usually place them in a separate category. To make sense of the distinction, we suggest that in today's terms it is more common for a company to have assets of $50 million or turnover of $30 million. Again, to be 'major' a company must rank in the first quartile or first third of its industry group in terms of size.It would be foolhardy, however, to insist on such discretionary standards. Only for those who want guidance, the investor should accept whatever rules he sets for himself and which in no way derogate from the common meanings of 'big' and 'small'. In the light of this case there will be many companies of which some are suitable for the strategic investor and some are not. Such diversity in opinion and action does no harm; rather it has a beneficial effect on shaper-market conditions, since it is more likely to lead to the splitting or changing of the primary and secondary stock market.

Conclusion : 

1. At the beginning of 1949, the average annual return earned by stocks over the previous 20 years was 3.1 percent. The average annual return earned by long-term Treasury bonds was 3.9 percent. That is, a $10,000 investment in stocks over this period would have grown to $18,415. The same amount invested in bonds would have grown to $21,494. Naturally, 1949 proved to be a great time to buy stocks: Over the next decade, the Standard & Poor's 500-stock index rose an average of 20.1 percent per year. In fact, this was one of the best long-term returns in the history of the American stock market.Graham commented on this topic in the opening pages. Just imagine what he would have thought of the stock market in the late 1990s. This was a period when every new record-setting gain was seen as proof that stocks were a way to build wealth without risk."
2. On September 3, 1929, the Dow Jones Industrial Average closed at a record high of 381.17. It did not rise above that level again until November 23, 1954, more than a quarter of a century later, when it reached a high of 382.74. (When you say you intend to hold on to stock for the long haul, do you know how long that might be? Many investors who bought these stocks in 1929 were not even alive by 1954. However, prudent investors reinvested their earnings and, as a result, their returns from stocks remained positive even during this gloomy period. This was possible because dividend yields averaged more than 5.6% per year. According to London Business School professors Elroy Disson, Paul Marsh, and Mike Staunton, if you invested a dollar in U.S. stocks in 1900 and spent all your dividends, your stock portfolio would have grown to $199 by 2000, but if you had reinvested all the dividends, your stock portfolio would have grown to $16,797. There is no doubt that dividends are a very important factor in investing in stocks.t * Why do 'higher stock prices' affect their dividend yields? A stock's poil is the ratio of its cash dividend to the price of a common share. If a company pays a $2 annual dividend when its stock is priced at $100 a share, its yield is 2 percent. But if the stock price doubles but the dividend stays constant, the dividend yield falls to 1 percent. By 1959 the trend Graham had observed had become obvious to all...
3. Most Wall Street experts declared that this trend could not possibly last much longer. Never before had stocks yielded a lower yield than bonds. After all, investing in stocks is riskier than investing in bonds. So, unless there was a chance of additional dividend income being paid from stocks to compensate for the higher risk, why would anyone buy them? The experts reasoned that bonds would yield higher returns than stocks for a few months, and then things would return to 'normal.' More than four decades later, the relationship has not normalized, with stocks yielding (so far) consistently below bonds yields. * For another view on diversification, see the sidebar in the note to Chapter 14.
4. Today, a defensive investor should insist on at least 10 years of continuous dividend payments. (This would eliminate the need to consider a member of the Dow Jones Industrial Average—i.e., Microsoft—though it would still leave at least 317 stocks to choose from in the S&P 500 index.) Even insisting on 20 years of continuous dividend payments would not be overly restrictive. According to Morgan Stanley, 255 companies in the S&P 500 met this standard as of the end of 2002.1 The 'Rule of 72' is a useful mental tool. To estimate how long it will take to double an amount, divide its projected growth rate by 72. For example, money at 6 percent will double in 12 years (72 divided by 6 = 12). A growth stock at the 7.1 percent rate quoted by Graham will double its earnings in just 10 years (72/7-1 = 10.1 years).
5. To show that Graham's observations always hold true, we can substitute Microsoft for JBUS and Cisco for Texas Instruments. Thirty years later, the results are strikingly similar: Microsoft's stock price fell 55.7 percent between 2000 and 2002. Cisco's stock, which had risen nearly 50-fold over the previous six years, lost 76 percent of its value between 2000 and 2002. As with Texas Instruments, Cisco's stock price decline was greater than the decline in its earnings. Cisco's stock price fell 39.2 percent during this period. (Compare the three-year average from 1997-1999 to 2000-2002.) As always, the faster a stock rises, the faster it falls. 'Earnings multiple' can be considered synonymous with P/E or price/earnings ratio. The pay multiple is how much an investor is willing to pay for a steak compared to the profitability of the underlying business.
6. Investors can now set up their own automated systems to keep track of the quality of their holdings using interactive portfolio trackers found on sites such as https://www.studyiq52.blog/2025/08/comment-on-chapter-4.html. finance https://www.studyiq52.blog, and https://www.studyiq52.blog/2025/08/comment-on-chapter-4.html, although Graham warns against relying solely on such systems. In addition to software, you should also use your own judgment.
7. To update Prime's figures, take each dollar amount in this section and multiply it by five.
8. To be considered large in today's markets, a company's total stock value (or 'market capitalization') must be at least $10 billion. According to the online stock screener at https://www.studyiq52.blog/2025/08/chapter-4-general-portfolio.html, in early 2003 there were about 300 stocks to choose from.