Dividend paying equities have always been core components of any defensive portfolio. Defensive investors by nature are part-active and part-passive. Before making a stock selection, the intelligent investor should keep two key concepts in mind. First they should question, whether they are investing or speculating with regards to a purchase that is made. Secondly they should question, whether a stock selection is good value by fully understanding the concept of margin of safety – the difference in market price versus underlying value.
The Intelligent Investor
The single most important intellectual development of defensive investing comes from a defensive investing mentor named Benjamin Graham in his book entitled “The Intelligent Investor”.
One of the most striking points made, is that over time, the general population views of what constitutes as ‘speculative’ versus an ‘investment’ has changed. During the early 1930’s all stock investments were viewed as speculative.
General attitudes considered stock investing equivalent to gambling. It was viewed as not safe and the general population was not familiar it.
In today’s world, we are bombarded by advertisements from banks and brokers where they heavily promote so called “investing” by using both expensive and convincing print-materials, television, radio, magazine and Online Ads.
Oddly, everyone who buys or sells a security or mutual fund, regardless of the price paid or what is purchased, is considered as an ‘investor’ in today’s world. But this is not so.
An important lesson illustrated here comes from Benjamin Graham. Not everyone in the market is an ‘investor’ and therefore the market contains many undesirable investment choices.
How does one know whether they are investing? Graham identifies an investment grade equity as one that provides a safety of principal and an adequate return. Investments outside of this definition are regarded as speculative.
There is no doubt that there is a speculative component to all equity investments. Where there is risk there is opportunity both for profit and for loss. An investor must be prepared financially and psychologically for adverse results that may be short or long-term in nature.
Graham defines risk as permanent loss or in other words ‘erosion of capital’. Accordingly, temporary declines in your holding do not necessarily define a true risk of loss. His rule is never to buy after a major advance and never sell after a decline.
A defining characteristic of all defensive stocks is that they pay a fair dividend. The whole purpose of investing money is to share in the profits of the entity.
Some of the money will be paid to you now, while the remainder will be reinvested, which should result in increased future dividends, earnings and ultimately share price.
An investment is proven unsafe when (1) a security is purchased for dividend and that dividend is discontinued or (2) an investor is required to sell at a price below what is paid.
Stock Investor vs Stock Speculator
The major distinction between an investor and the speculator is in their attitude towards stock market movements.
The speculator primary interest lies in anticipating and profiting from market fluctuations while the investor’s primary goal lies in acquiring and holding suitable securities at suitable prices.
Low prices provide an investor an opportunity to buy and high prices an opportunity to sell. The more optimistic the market gets over a stock and the faster its advances relative to earnings, the riskier the stock becomes. A continuous dividend paying record is extremely important with a proper dividend payment policy.
Findings show that companies in which the market has high expectations, as measured by the above ratios, have consistently performed the worst. The reason is, that a market premium is paid for near term ‘visibility’ on earning prospects.
To evaluate the value of a company, forecasts must be made with extreme accuracy into the future. We have already discussed this earlier – this is very difficult to do. Investors and analysts also have confidence and optimism that earnings expectations will be met. Over-confidence about information and forecasts, a reliance on ‘experts’, and over-optimism leads to a deadly combination.
This is something that you can easily see for yourself. Identify the latest stock market darling and follow it until a negative earning surprise occurs.
Findings also show that companies in which the market has low expectations, as measured by the below ratios, have consistently perform the best. Low expectations is what the defensive investing strategy is based on.
A study by David Dreman and Eric Lufkin, looked at the largest 1,500 publicly traded companies over 27 years. The below table shows the significant results obtain by using this strategy over the long term.
|$10,000 Initial Investment
A low P/E ratio (Price relative to Earnings) is often thought of as a typical value investing strategy. This is a relatively straightforward strategy that saves an investor from over- managing a portfolio and helps reduce commission costs. This strategy doesn’t require a lot of work to be effective. Initially, you want to position yourself carefully and make fine tunings to the portfolio as needed.
Low P/E stocks also tend to have higher dividend returns which helps maintain the value of the stock through bear markets.
Also used are the Low P/CF (Price relative to Cash Flow), P/BV ( Price relative to Book Value), and P/D (Price relative to Dividend) ratios. Specifically P/BV is a tool that is heavily favoured by value guru Benjamin Graham.
Essentially this strategy buys solid companies that are currently out of favour as measured by their low price to earnings, price to cash flow and price to book value.
Most expensive (i.e. companies to avoid)
- High PE
- High P/CF
- High P/BV
- High P/D
Least Expensive (i.e. companies to investigate)
- Low PE
- Low P/CF
- Low P/BV
- Low P/D
Positive earning surpriseshave a positive benefit to low P/E stocks and generally a neutral influence on high P/E stocks. Negative earning surprises have less effect on low P/E stocks than on high flying P/E stocks.
Expectations are very great for high P/E stocks: earnings disappointments are inevitable and it becomes only a matter of ‘when’.This can be seen easily in the latest technology boom in companies with outrageous valuations. Expectations of low P/E stocks are already low; therefore, a negative surprise will often have less effect.