For a dedicated stock-picker with entire days to spend on research and enough backing capital to accept some serious risk, picking speculative stocks that could rise high or crash hard can be an attractive game to play. Going after bigger gains can more than make up for the risk if you're in a position to take a hit periodically when you pick wrong.
However, for most investors, what little savings can be scraped together are necessary for retirement or a child's college education. Putting those funds at risk could have disastrous consequences, so minimizing risk is more than worth the reduces potential gains involved. As such, Benjamin Graham, legendary godfather of value investing, wrote about a screen for stocks for the defensive investor in his 1949 tome The Intelligent Investor. While much has changed about investing over the last 60 years, Benjamin Graham's lessons remain well respected and utilized by many of the best investors. In particular, Graham's advice for a more conservative, risk-averse portfolio remains generally sound.
A Stock Screen for a Conservative Portfolio
In The Intelligent Investor, Graham lays out seven criteria to put stocks through before investing in them should you qualify as a defensive, more conservative investor.
1. Adequate Size of Enterprise
Smaller companies are more prone to large swings in value, so larger companies naturally have a greater degree of stability.
2. Sufficiently Strong Financial Condition
Graham felt that a defensive investor should only invest in companies with strong balance sheets, with relatively little debt. This meant a Current Ratio of at least 2, long-term debt should be less than working capital, and assets should be at least double the company's debts.
3. Earnings Stability
Consistent earnings are a sign of stability, and for defensive investors a good company to invest in should not have shown a loss at any point in the last decade.
4. Dividend Record
A strong history of dividends means that an investor should be able to rely on that company to continue paying them in the future. Graham suggested investing only in companies that have at least 20 years for its common stock.
5. Earnings Growth
A company's profits need to stay on pace with inflation, so Graham suggested companies where net income increased by at least one third or more over the last ten years.
6. Moderate Price to Earnings Ratio
A low price to earnings ratio represents a good price for the money a company's making. Graham suggested a P/E ratio of 15 or lower for defensive investors.
7. Moderate Ratio of Price to Assets
Graham suggested that, for the defensive investor, a company's stock value shouldn't be more than 1.5 times its book value.
The defensive investor needs to act in ways that protect their assets for the future. In many cases, this means reducing potential gains in the long run, but the results can also mitigates much (but NOT all) of the risk involved with investing.