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Benjamin Graham: Golden Rules for Picking Defensive Stock


With current market condition that is so uncertain, what would you do? Would you fold your hand and keep the money? But what if your hand is itchy again? If that’s the case, the best choice for now is to invest on defensive stock. Defensive stock, here, refers to stock that are more stable and less vulnerable to market changes. It is usually a large cap company that has been standing long in the market. So, what are the 7 criteria that Benjamin Graham emphasizes on while screening for defensive stock?

Benjamin Graham rule of thumb in picking stocks

Large companies such as MAYBANK, TENAGA, BAT, NESTLE have been operating for nearly half a decade. These companies have already secured a large market share and are less vulnerable to any market changes. Even if their quarter result dip for a quarter or few, the companies are more likely to endure through it and come back stronger. Meanwhile, companies with small capital could easily be affected when the economic falls.
A defensive stock must be backed by a healthy financial condition. A good defensive company is defined by Graham to have at least a current ratio of 2. This means that the current asset of the companies should be at least two times more than its current liabilities. By having a current ratio of 2 and above, this signifies that the company will have enough current assets to cover its short term liabilities. This will again, ensure a company can survive through tough time. Moreover, its long term debt should be less than its working capital, which is also known as the net current assets.

Current Ratio, Working Capital and Net Current Assets

Is the stock consistently earning money? Or is it just a stock that have its earning fluctuates over the years? Imagine you own a small restaurant. In the first few months of year, you have plenty of customers. But then for the next half year, you have no customer at all. Coming to the end of the year, you even have no more capital to pay your workers. Do you think a business like this could sustain? Therefore, Graham suggests to invest in stock that shows at least 10 years of earning consistently.
Graham also recommends to pick a stock that constantly pay dividend for at least the past 20 years. Nevertheless, I think setting the benchmark to be 20 years could be a bit difficult for KLSE market. Anyway, I agree that dividend payment is by far the most important criteria while picking a stock. Although earning from dividend is not as rewarding as capital gain, it is the only source of income that you can count on when the stock market tumbles.
According to Graham, for a defensive stock, it does not need to record high profit jump. A stable growth of 1/3 in Earning Per Share for the past ten years are considered good enough to invest in.
P/E ratio is an indicator of investors’ confidence towards a stock. A high P/E ratio signifies that investors are feeling hopeful about the future of a company, thus willing to pay a high price for the stock. Nevertheless, it is always downfall that awaits when the unduly positivism peaks. So, try to limit yourself buying a stock with a current price less than 15 times average earnings for the past 3 years. PE<15.
Imagine that you want to buy a second hand 2010 Toyota Vios. The market price of the car is RM38000. But the buyer requests to sell it at RM40000. Would you buy it? Absolutely no way, right? But why does this rationale does not apply in stock investment? Paying excessive high price to asset value is unjustifiable. As Graham recommend, the buying price should not be more than 1.5 times the book value. Here, remember that the book value refers to only tangible assets but not intangible assets such as goodwill or trademark. Even better, opt for Price to Tangible Book Value (PTBV) for a clearer picture on whether the stock is overpriced.
So, this is the 7 parameters that Benjamin Graham advises to look into while picking a defensive stock.

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