Chapter 5: The Defensive Investor and Common Stocks

Rules for the defensive investor:
1. In order to have diversification, an investor should have 10 to 30 different stocks.

2. The underlying company should be large and managed conservatively. "Large" can be defined as market capitalization of 10B$ in today's market.

3. The underlying company should have a long track of paying dividends.

4. Maintain margin of safety on the purchase price of a stock. As an example, set a limit of 25 times average earnings over the past 7 years and less than 20 times of the earnings in the last 12 months.

By reading point #4 above, by definition, a growth stock is expected to continue with increase in per-share earnings in the future and this increase is already factored in the stock price. Therefore, there is a speculative element in buying growth stocks.

Concept of "risk"
Risk and safety can be applied in different context when it comes to stocks and bonds. When a bond defaults on its interest and principal payments, it has deemed unsafe. Likewise, when there is a reduction of dividend on an underlying stock, that stock is deemed unsafe since there were expectation of dividend payments.

The concept of risk applies to a decline in the stock price even though the decline may be temporary. But this may not be a true risk in the general sense of the word. True risk occurs when there is a possibility of losing money either through an actual sale or a deterioration in the underlying business.