Part 14:  Implementing Strategies with Security Analysis

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💥 Why This Matters

• Beware of Market Extremes: 1929, 1968, 1999 and 2008 are all examples how market sentiment can drive valuations to unsustainable levels.

• Quantitative Criteria as a Guide: Applying objective criteria such as size, financial strength, earnings stability over time, etc. can help investors identify potentially undervalued companies and avoid overpaying for growth.

• Diversification and a Long-Term Focus: For defensive investors, diversification is key to mitigating risk and achieving satisfactory returns. Avoid trying to predict the “best” stocks and instead focus on building a well-rounded portfolio of quality companies. 

📝  Introduction

The quote from Sir Francis Bacon highlights the importance of a balanced approach to wealth-building by advocating for caution and prudence in financial decisions.

For example, the first part of the quote says that by relying solely on guaranteed, safe, or conservative methods (like secure investments or cautious business practices) – that might prevent someone from achieving substantial wealth.

On the other hand, if someone takes too many high-risk ventures without safety nets, they risk losing everything. Adventurous or speculative investments can yield great rewards but can also lead to financial ruin.

The key is to find the right balance.

Chapter 14 demonstrates how diligent analysis (per the previous chapter) plays a crucial role in implementing investment strategies for both defensive and growth-oriented investors.

This chapter focuses on how defensive investors can utilize security analysis to build a diversified portfolio of high-grade bonds and leading common stocks, ensuring they acquire these assets at reasonable prices.

📋 Two Approaches to Stock Selection

Defensive investors can choose between two primary approaches when building their stock portfolio:

1. Index Based Portfolio: This approach involves creating a diversified portfolio by investing equal amounts in a representative index like the S&P 500. For example, Vanguard’s VOO ETF mirrors the returns of the S&P 500 at a very low expense ratio (0.03%). This provides a broad market exposure and includes both growth and value stocks

2. Quantitatively-Tested Portfolio: This approach involves applying a set of quantitative criteria to each stock selection, ensuring a minimum level of quality and value. This method emphasizes objective measures and focuses on identifying undervalued companies.

For most investors who neither have the time (or skill) to choose individual stocks – I would strongly recommend an Index based approach to investing – using dollar-cost averaging (i.e., defined amounts at regular intervals). 

🧮 Quantitative Criteria for Stock Selection

For the investor seeking returns which outperform the Index (i.e., a more active approach) – the following seven criteria are suggested for selecting individual stocks in a quantitatively-tested portfolio:

• Adequate Size: Focus on larger, more established companies with at least $1 billion in annual sales for industrial companies and $500 million in total assets for utilities (note – these are inflation adjusted values for 2024)

• Strong Financial Condition: Look for companies with a current ratio (i.e., current assets / current liabilities) of at least 2; and long-term debt not exceeding net current assets (for industrials); or twice the stock equity (for utilities). With respect to long-term debt – this represent the company’s working capital or liquid assets after covering short-term obligations

• Earnings Stability: Ensure the company has a history of consistent earnings without any deficits in the past ten years. Consistent earnings indicate that the company is well-managed, has a solid business model, and can operate profitably over time (i.e., through good and bad economic cycles)

• Dividend Record: Prioritize companies with a long history of uninterrupted dividend payments, ideally for at least 20 years. Whilst I understand Graham’s philosophy here – for me personally – I put less weight on dividends (e.g., investing in large-cap tech the past 15 years). I would rather the companies retain the cash and reinvest in growth. However, this is a function of your investment philosophy. 

• Earnings Growth: Seek companies with a minimum earnings growth of at least 33% over the past ten years, using three-year averages. With respect to using averages – this will smooth out any fluctuations that might result from temporary market conditions or one-time events. For instance, a company might have a particularly good or bad year, but averaging over three years offers a more accurate view of its consistent earnings trend.

• Moderate P/E Ratio: The current stock price should not exceed 15 times the average earnings of the past three years. Personally, I would be okay adjusting this ratio higher to around 18x (the average PE for the S&P 500 between 2014 and 2024). However, as you move above 20x, ensure you’re buying the highest of quality companies

💯 Paying “Fair” Prices for “Wonderful Businesses”

When Warren Buffett started investing – he followed the strict value-investing approach inspired by Graham (as outlined above).

He focused exclusively on finding deeply undervalued stocks that could be bought at a significant discount to their intrinsic value, even if these companies had poor growth prospects.

He called this “cigar-butt” investing, focused on buying stocks that were cheap based on their balance sheet value or other measurable assets, even if they weren’t necessarily quality businesses.

However, Charlie Munger changed all that.

Munger convinced Buffett to shift from buying “cigar-butt” companies to paying a “fair price” for “wonderful companies” with strong long-term prospects (e.g., Apple, Coke, Amex – it’s a long list).

This shift in philosophy is one of the most defining evolutions in Buffett’s investing approach – calling Munger the “architect” of Berkshire Hathaway success upon his passing in 2023.

“In the physical world, great buildings are linked to their architect while those who had poured the concrete or installed the windows are soon forgotten. Berkshire has become a great company. Though I have long been in charge of the construction crew; Charlie should forever be credited with being the architect.“

— Warren Buffett

If nothing else, this demonstrates Buffett’s great humility (one of his many qualities).

• Adequate Size: Focus on larger, more established companies with at least $2 billion in annual sales 

• Strong Financial Condition: Prioritize companies with current assets at least twice their current liabilities; and long-term debt not exceeding working capital (i.e., current assets less current liabilities). Look for companies with ample cash and low debt levels. Note: with longer-term bond yields likely to rise in subsequent years (e.g. the US 10-year above 5.0%) – this will become critical. 

• Earnings Growth: Look for companies with cumulative earnings growth of at least 50% (e.g., CAGR of at least 4%) over the past decade.

• Moderate Price-to-Book Ratio: Consider the price-to-book ratio in the context of intangible assets, recognizing that higher multiples may be justified for companies with strong brands or intellectual property. Aim for a ratio below 2.5, or use Graham’s blended multiplier (P/E x P/B) to identify reasonably priced stocks

✅ The Role of Selectivity and Prediction

While every investor desires a superior portfolio, attempting to predict the “best” stocks is inherently challenging.

Market prices generally reflect both known facts and future expectations, making it difficult to consistently outperform the market through individual stock selection.

Two main approaches to security analysis exist:

1. Prediction: This approach focuses on anticipating future performance, often relying on qualitative factors like industry trends and management quality.

2. Protection: This approach emphasizes identifying undervalued companies with a margin of safety, focusing on quantitative measures and historical data

Diversification remains a cornerstone of defensive investing.

By spreading investments across various stocks and industries, investors can minimize the risk of significant losses due to poor performance of individual holdings.

Diversification also increases the chances of capturing the returns of “superstocks” that achieve exceptional growth (e.g., large cap tech the past two decades).

🌐 Diversification over Prediction

For defensive investors, diversification is more important than attempting to predict the “best” stocks.

By holding a diversified portfolio, investors can reduce risk and potentially achieve satisfactory returns without relying on uncertain predictions.

While some room for individual preferences exists, overemphasizing selectivity can be detrimental.

Defensive investors should focus on building a well-rounded portfolio that meets their criteria for quality and value, allowing them to participate in market gains while minimizing downside risk.

 Key Takeaways

• Stock Selection for Defensive Investors: Defensive investors can choose between a diversified index-based approach; or a quantitatively-tested portfolio that applies strict criteria to ensure a minimum level of quality and value. The latter emphasizes using objective measures to identify undervalued companies that align with high financial standards. However, this requires significant work, time and skill.

• Seven Quantitative Criteria for Stock Selection: Key criteria for stock selection include adequate company size, a strong financial condition, consistent earnings stability, moderate earnings growth (at least 33% growth over ten years), and reasonable price-to-earnings and price-to-book ratios. These metrics ensure that the chosen companies are financially sound and provide defensive investors with a margin of safety.

• Importance of Diversification and Due Diligence: Diversification is essential for defensive investors to spread risk across various stocks and industries, reducing potential losses from poor individual stock performance. Additionally, thorough due diligence is necessary to validate each investment, including reviewing financial reports and assessing institutional ownership to confirm quality and alignment with Graham’s criteria