The Intelligent Investor: The Defensive Investor and Common Stocks

Benjamin Graham’s book The Intelligent Investor, first published in 1949, offers advice that is based on discipline and discernment.The book may be decades old, but much of his advice remains relevant today, as investors navigate information overload, market noise and all kinds of volatility. In the last blog, we looked at his suggested portfolio framework for the defensive investor. In this blog, we’ll look at his advice on why defensive investors should invest in common stocks and some rules to follow while doing it.

Defensive investors and the stocks + bond approach

When Benjamin Graham first wrote about investing in 1949, common stocks were widely considered dangerous. By the late 1960s and early 1970s, however, the mood had reversed. After a long bull market pushed the Dow Jones Industrial Average to historically high levels, stocks were increasingly viewed as safe and reliably profitable. Graham warns against both emotional extremes. When investors fear stocks too much, they miss opportunity. When they trust them too blindly, they invite disaster.

In spite of this, Graham encourages defensive investors to invest in stocks. The reason? Bonds alone do not provide adequate protection or returns, especially when inflation is factored in. Fixed-interest securities lose purchasing power over time, but stocks offer ownership in businesses that can grow their earnings and reinvest those profits. So on the long run, stocks tend to deliver higher returns than bonds, through dividends and through capital appreciation.

What defensive investors should keep in mind when selecting common stocks

Here are some guidelines Graham lays out for stock picking for the defensive investor.

• Diversification: A defensive investor should own a reasonably broad selection of companies. This reduces the impact of any single business failure without diluting the portfolio into meaningless over-diversification.
• Choose well-established companies:  Graham says the companies chosen should be large, well-established, and conservatively-financed. Graham uses the words “large” and “prominent” to describe firms that hold strong positions within their industries. Financial conservatism, in his framework, means that companies should not rely excessively on debt. A substantial portion of their capital structure should consist of equity rather than borrowed money.
• Look for a dividend payment history: Another must in Graham’s book is a long and uninterrupted record of dividend payments. When a company has a continuous dividend history, it shows durability across economic cycles. It indicates that the business has survived recessions and remained profitable enough to reward shareholders consistently.
• Do not overpay: Graham suggests imposing a strict limit on the price paid relative to earnings. He says defensive investors should avoid paying more than 25x average earnings over a seven-year period, and no more than 20x the most recent year’s earnings. This rule effectively excludes most trendy high-growth, “buzzy,” which may be overvalued.

To sum it all up…

Graham says that the defensive investor needs to take a balanced approach to hold both stocks and bonds: diversification is key. He advises investing in large, financially strong companies, instead of trendy “growth” stocks, and to never overpay. The rewards are in long-term holding, so he cautions against getting caught up in market fluctuations. Discipline, not excitement, is what counts — so success depends on prudence, patience, and sound principles.