Defensive Investing Strategy

There seems to be a lot of talk about stock dividends and other fixed income investments.  Dividend paying equities have always been core components of any contrarian’s portfolio.  Contrarians 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 single most important intellectual development of defensive investing comes from our mentor 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 and magazines 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.

A few years ago, a poor friend of mine, relatively new to investing arrived from China with $300,000 USD in cash.  Her broker recommended historically unproven and expensive companies like Amazon, @ Home and Nortel Networks.  She truly believed that she was investing, while it is now clear that she was speculating.  Unfortunately, she returned to China poorer, and took a strange solace in her loss knowing that she was not alone.

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.  

Many stocks are lethal to your financial health.  Unfortunately, part of the population may actually be speculating while believing that they are investing.

How does one know?  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.

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.

Contrarian Investor Spectrum

 

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