It's time for another installment in my The Intelligent Investor series.
On page 348, Graham covers his seven statistical requirements for inclusion in the defensive investors portfolio. His seven criteria are:
1. Adequate Size of the Enterprise
2. A Sufficiently Strong Financial Condition
3. Earnings Stability
4. Dividend Record
5. Earnings Growth
6. Moderate Price/Earnings Ratio
7. Moderate Ratio of Price to Assets.
Today we'll finish up by covering 4-7.
4. Dividend Record - Graham requires uninterrupted payments for at least the past 20 years. While this is a lofty goal, I prefer to invest in a company that is raising their dividend annually by more than the inflation rate. This provides stability and an increasing of your purchasing power. If a company can continue to increase it's dividend you will be able to still purchase the same amount of goods the next year. This is one of the best tests if your planned route is to be able to live off of the income stream provided by dividends thrown off from companies.
5. Earnings Growth - His requirement here is a little too conservative for my liking. He wants to see a minimum increase of one-third in per-share earnings in the past 10 years using 3 year averages for earnings. For example, if you're looking at the earnings growth of a particular company now you would take the average of the per-share earnings from 2009 to 2011 versus the average earnings from 2000 to 2002. Average earnings should have increased by at least 1/3 in that time, or a 33% increase. The reason I find this to be too conservative is that a 33% increase over 10 years equates to only a 3% annual rise. This is still a good baseline because it shows improvement; however, taking a 50% increase equates to a 4% annual increase and a 100% increase is a 7% annual rise.
6. Moderate Price/Earnings Ratio - I like his standard here. His criteria is that current price not be more than 15 times the average earnings of the past 3 years. The reason I like this is because if a company has met the earnings growth criteria it's earnings from 3 years ago should be less than the latest current year bringing down the average earnings. This is another way to help insure that you are purchasing with a good margin of safety.
7. Moderate Ratio of Price to Assets - Graham requires that the current price not be more than 1.5 times the latest reported book value. He also introduces a blended multiplier in which the price to book multiplied by the price to earnings be less than 22.5. This would allow for a company trading at a higher price to book but a lower price to earnings still meet the 22.5 criteria and vice-versa.