Stock selection for today's defensive investor

Picking your own stocks

Regular readers will know that for most average investors, I'd suggest not trying to be too clever wiht picking your own stocks and instead investing consistently and regularly into a diversified Listed Investment Company with heavy exposure to industrials and financials.

Most people don't, though, and they prefer to pick their own stocks. Nothing wrong with that in itself, of course. The trouble is, people often ask me if I like 'XYZ' stock, and when I ask them why they like it, the answers are usually one of the below (or at least, something along similar lines):
  • "I just like 'the look' of the company..."
  • "The price has fallen 25% and I reckon it will bounce."
  • "My mate down the pub tipped XYZ as the next 10 bagger..."
To be frank, if you aren't going to carry out any worthwhile analysis into whether a company's financials stack up, you might as well stop pretending that you are investing and call it what it is: gambling or guessing. The share price should be the last of the criteria to look at - not the first!

I'd still suggest that if you're a monthly salary earner the most sensible way to invest is to write yourself a signed contract which says that you will pay a regular amount into a well-diversified LIC with a low management expense ratio each month or each quarter for as long as you possibly can. When the market is low, buy harder, and focus on the growing dividend streams.

Still, that's not to say you shouldn't invest in individual stocks too. But with the market going on a tremendous surge in the year through to May, how might you invest defensively now that the market is more expensive today?

Well, let's go right back to the doyen of value investing himself, Mr. Benjamin Graham. In the most recently updated version of his classic investment book The Intelligent Investor, which Buffett described as by far the best book on investment ever written, Graham includes a chapter on stock selection for the enterprising investor and  a chapter on stock selection for the defensive investor.

Graham suggests 7 criteria for defensive stock selection. Let's take a look and then apply to Australia's stock market of today.

1 - Adequate size of the enterprise

In Graham's last version of The Intelligent Investor, he refers to business with a turnover of "at least $100 million" for industrial companies or "$50 million for a public utility". That would make for a relatively small business today.

Smaller companies can show great growth potential, but that is not the point of the discussion here, where we are seeking solid, defensive investments. Today, an enterprise of an "adequate size" might refer to a company with a market capitalisation of at least a couple of billion dollars.

2 - Sufficiently strong financial position

Graham suggests current assets should be at least twice current liabilities, which we would call a 'two-to-one' current ratio. We should also remember from the financial crisis (when leveraged companies such as Centro were hugely exposed) the dangers of high levels of debt and interest cover ratios.

For this reason, Graham suggests that long-term debt should not exceed the net current assets (and for a public utility debt should not exceed twice the stock equity at book value).

3 - Earnings stability

Graham insists on some earnings (profits after tax) for each of the past ten years.

4 - Dividend record

Uninterrupted payments for the past 20 years.

5 - Earnings growth

Graham speaks of a minimum increase of at least one-third in per share earnings in the past 10 years using three year averages at the beginning and end.

6 - Moderate Price-Earnings ratio

Fashions come and go to some extent relating to PE ratios, but Graham suggests a PE ratio of not more than 15.

7 - Moderate ratio of price to assets

The current share price, says Graham, should not be more than 1.5 times book value (note: strip out intangibles such as franchises and licences).

Using these criteria in today's Aussie stock market?

There has been much recent talk of a "bank bubble" in Australia. With the banks paying very strong dividends and generating giant profits, share prices went roaring upwards from late 2011 before experiencing quite a sharp correction through May. So, let's take a look at how Graham might have analysed the bank stocks from a defensive investor's perspective.

Naturally, all of Australia's 'Big 4' major banks meet the size criteria, being of large market capitalisation - Commonwealth Bank (CBA) has a market capitalisation of around an incredible $108,000 million! And they have consistently increased profits and paid strong dividends, thus meeting these criteria also.

CBA's 2012 Annual Report (page 7) shows the Groups Return on Assets and cash net profit after tax (NPAT) moving upwards very strongly. And CBA's full year dividend has increased from 224 cents per share at June 2008 to 334 cents per share for June 2012. Magic.

Earnings stability for the banking sector has been reasonable and the sector presently has low 'Beta' values. So far, so good.

Strong financial position?

Let's take a look at the balance sheets from the Commonwealth Bank (CBA) 2012 Annual Report.

Whoa! Take a look at the liabilities: deposits and other public borrowings of $437,655 million as compared to net assets of only $41,572 million? High leverage.

The top half of the balance sheet (the bank's assets) show loans due of more than $525,682 million which the notes to the accounts show overwhelmingly relate to home loans in Australia ($320,570 million) and overseas home loans ($30,063 million) such as in NZ.

So the banks are unusual beasts with massive exposure to residential property. Naturally mortgages are issued are usually secured against property worth more than the loan but with a net asset position of only $40 billion against home loans of $350 billion, CBA has exposure to loans going bad. Of most concern would presumably be some of the 100% LVR loans which were being dished out before the financial crisis.

On the plus side, unlike physical residential property, bank stocks are liquid. You can choose to sell up at any time, which is not always so easy to do with an illiquid asset such as a house.

Of course, the banks undertake all manner of risk management solutions, capital adequacy and stress tests, but the transparency and disclosure thereof is questionable. New rules will gradually come into place, commencing with the regulatory standard BASEL III in coming years.

So, would Graham dare to venture into the banks as highly leveraged as they are? Well, he might because the banks are seen as "too big to fail" and receive an implied guarantee from the Government and have the potential to earn great profits. However, at today's prices, as I'll explore in more detail below, the banks do not meet the criteria for defensive investors.


With regards to earnings growth, Graham talks of a benchmark of one-third growth in per share earnings over ten years, which implies growth of less than 3% per annum. Times change and I would suggest that today this hurdle is probably too low. I'd want to see growth of 50%, thereby closer to 4% per annum. No matter, for the purpose of this discussion, the banks can score a pass here.

Graham suggests PE ratios of not more than 15. Commonwealth Bank (CBA) has experienced a correction of close to 10% in recent weeks pulling back from above $74 per share to $65 per share, and as I write this has a PE ratio of 14, which is reasonable under Graham's criteria, with the other major banks trading at lower PE ratios than this.

Incidentally, for defensive investors, I wouldn't recommend the practice of using next year's forecast earnings to calculate the so-called "forward PE ratio". Why? Because it makes more sense to use known actual numbers than forecast future ones which are often wildly inaccurate! Detailed research by David Dreman in the US showed that forecast earnings 'miss' by more than 15% more than half of the time!

Price-to-book value issues?

But what about the price-to-book ratio? Well, here's where Graham would have a problem with some of Australia's major banks as defensive investments, as the price-to-book valuations are all higher than 1.5. CBA has is trading at a price-to-book of somewhere just over 2.5 (market cap of more than $100 billion, net assets at the 2012 full year reporting date of somewhere just above $40 billion as noted above).

Westpac (WBC) has a PE ratio of 13 and price-to-book of 2. And ANZ clocks in at PE of 12 and price-to-book of 1.9. Only NAB is close to meeting Graham's criteria at a price-to-book of 1.6 and a PE of 12 (NAB today has a market cap of $69 billion and its 2012 Annual Report shows net assets of a shade under $44 billion).

Is it sometimes OK to pay more?

Graham suggests that a PE ratio of lower than 15 can sometimes justify a correspondingly higher price-to-book (he suggests that the product of the PE multiplier and the price-to-book should not exceed 22.5 - i.e. 15 multiplied by 1.5).

Take a look at CBA with this in mind with its PE of 14 and a price-to-book of 2.5, giving a total of more than 30. That's way too expensive for a defensive investor in Graham's eyes.

On these criteria at least, WBC looks a little overvalued, while ANZ looks reasonable. NAB, which has been less in favour with investors, could be a goer, with its significantly lower price-to-book of 1.6, although a defensive investor would still be very wary of a banking sector correction. 

Here is where the judgement call comes in...

Australia's banks have historically been seen as rock-solid investments, partly because they effectively receive an implicit guarantee from the Government as they are seen as "too big to fail". For this reason, analysts deem it appropriate to value banks such as CBA  at way over twice the book value, even in today's uncertain climes.

Graham's insistence for defensive investors on relatively low PE ratios and price-to-book ratios is often seen as unfashionable today, with many analysts suggesting that companies with growth prospects justify an expensive share price and should be bought regardless.


So, there you have it. Going back to the time-honoured principles of defensive value investing, the major banks such as CBA, ANZ and WBC do not qualify as defensive investments.

I hold shares in all of them and some of the smaller banks (both directly and indirectly through LICs because I focus on the growing dividend streams) but must acknowledge that at today's share prices a correction could potentially be quite sharp. If that does eventuate and prices fall sharply I would be looking to buy more.

However, if you have an investment plan that sees you worrying about a share prices falling in the short term (CBA is trading at a premium to its book value which is 40% too high for Graham's defensive investor criteria and he'd prefer to see it trading in the $40-$50 range) then other stocks offer a more defensive investment strategy.


Disclaimer: I don't advise on individual shares to buy or sell. Each individual investor has a different financial profile, so consult a licensed professional before committing to any investment decisions.

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