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What can today's investors learn from someone who last wrote on investing nearly 40 years ago? While the market has changed dramatically since Benjamin Graham last opined about it in Intelligent Investor, those interested in value investing, or investing in general, can still learn a lot about investing in stocks today.
With that in mind, I am doing a series of articles, beginning with Part 1, which will break down what I found personally useful in Graham's writings.
Two types of investors
In general, investors should aim for returns in line with the risk they're willing to run. However, Graham looks at things a bit differently. He breaks intelligent investors into two distinct groups based on the "amount of intelligent effort [one] is willing and able" to spend on his investments. A defensive or passive investor seeks safety and freedom from concern, while the enterprising investor takes a more active role in researching stocks, maximizing return by taking a more active role in choosing investments.
A passive investor might buy a handful of mutual funds and rebalance every year to match a preferred allocation based on age. An enterprising investor might be someone with 100% of available money allocated to 10-15 stocks, constantly researching to find the next great pick. There is nothing wrong with either, so it is up to the individual investor to find what works best for them.
The defensive investor and stocks
With all that said, a defensive investor could also build a portfolio with minimal effort and reap the benefits of investing in individual stocks. While mutual funds come with professional managers with a public track record, fees can often eat away at gains gradually over time. To find potential stocks, Graham proposes four rules for the defensive investor:
- "Adequate but not excessive diversification"
- "Large, prominent, and securely financed" companies
- "Long record of continuous dividend payments"
- "A limit on the price he will pay ... in relation to average earnings"
Graham's definition of diversification is "a minimum of 10 issues and a maximum of about 30." While the size of your portfolio may dictate how many different companies you own in your portfolio, it is a good idea to spread your investments out over various industries. Dividends aren't nearly as prevalent as they were in Graham's day, so there is room in the defensive investor's portfolio for non-dividend paying stocks. Two of the largest companies on the S&P 500 don't currently pay dividends: Apple (Nasdaq: AAPL ) and search giant Google (Nasdaq: GOOG ) . Both companies have large cash piles and seem stable enough to start paying a dividend, but seem reluctant to do so.
A great place to find stocks for the defensive investor is the Dividend Aristocrats, or S&P 500 companies that have raised dividend payments every year for at least the past 25 years. One of the longest serving "Aristocrats," which also meets the other requirements of Graham's short list above, is industrial conglomerate 3M (NYSE: MMM ) . The company has a 53-year history of raising its dividend, resulting in a solid yield of around 2.7%. Beyond that, its own diversification can also help investors with smaller portfolios to not feel the wrath of one sector performing poorly over another.
The enterprising investor and stocks
As mentioned above, the enterprising investor takes a more active role in picking stocks. Graham outlines four activities that enterprising investors should focus on:
- "Buying in low markets and selling in high markets"
- "Buying carefully chosen 'growth stocks'"
- "Buying bargain issues of various types"
- "Buying into 'special situations'"
While Graham goes out of his way to indicate timing the market is closer to speculation, an enterprising investor can still "buy low and sell high" regardless of the overall market by establishing a fair value for their investments and buying and selling based on a pre-determined price.
Graham doesn't specifically say how to identify a growth stock, only that enterprising investors should avoid stocks where "the excellent prospects are fully recognized in the market and already reflected in a current price-earnings ratio of higher than 20." It's up to the individual investor to identify what their upper P/E limit would be, but many great stocks with growth potential have P/E ratios well over 20. Fool favorite Intuitive Surgical (Nasdaq: ISRG ) , which has grown revenue at a 37.6% annual pace over the past decade, and Chipotle Mexican Grill (NYSE: CMG ) , which has seen a 22.5% annual growth in revenue over five years, both carry high earnings multiples.
What it all means
What kind of investor you are can depend on a variety of factors and be defined in numerous ways, but I like Graham's notion of defensive versus enterprising when it comes to investing. Either one can result in strong returns for your portfolio. For the next article in this series, I will delve deeper into some ways that Graham himself valued stocks, as well as stock selection for Graham's two types of investors.
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