Defensive Investor Screening

Defensive Investor Screening

Apply Benjamin Graham's seven criteria to identify stocks suitable for conservative, safety-focused investors who want adequate returns with minimal effort and risk.

When to Use

• Building a conservative stock portfolio
• Evaluating whether a stock meets defensive standards
• Screening candidates for long-term holding
• Assessing quality and safety of established companies
• User asks "Screen for defensive stocks" or "Is this suitable for a defensive investor?"

Inputs

The Defensive Investor

Graham defined the defensive (or passive) investor as someone who:

• Wants adequate but not spectacular returns
• Is unwilling to devote significant time to analysis
• Seeks to avoid serious mistakes
• Prefers safety over maximum gain

"The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition."

Graham's Seven Criteria

Criterion 1: Adequate Size

Requirement: Minimum sales of $500 million (inflation-adjusted from Graham's original $100 million)

Rationale: Large companies are more stable, better researched, and less likely to disappear overnight. Size provides a margin of safety through staying power.

Evaluation:

• Annual revenue exceeds $500 million
• Note: Adjust threshold for inflation from Graham's era

Criterion 2: Strong Financial Condition

Requirement:

• Current ratio (current assets / current liabilities) > 2:1
• Long-term debt should not exceed net current assets (working capital)

Rationale: Strong balance sheet protects against financial distress. A company that can pay its bills twice over from current assets has staying power.

Evaluation:

• Current ratio > 2.0
• Long-term debt < (Current assets - Current liabilities)

Criterion 3: Earnings Stability

Requirement: Positive earnings in each of the past 10 years

Rationale: A company that has never lost money over a decade demonstrates durability. One bad year can be forgiven; consistent losses indicate structural problems.

Evaluation:

• No net losses in any of the past 10 fiscal years

Criterion 4: Dividend Record

Requirement: Uninterrupted dividend payments for at least 20 years

Rationale: Long dividend history indicates:

1. Consistent profitability (can't pay what you don't earn)
2. Shareholder-friendly management
3. Mature, stable business model

Evaluation:

• Dividends paid every year for 20+ consecutive years

Criterion 5: Earnings Growth

Requirement: Minimum increase of at least one-third (33%) in per-share earnings over the past 10 years, using three-year averages at beginning and end

Rationale: Even defensive investments should grow. A 33% increase over 10 years is modest (roughly 3% annually) but ensures the business isn't declining.

Calculation:

Beginning average = Average EPS of years 1, 2, 3
Ending average = Average EPS of years 8, 9, 10
Growth = (Ending - Beginning) / Beginning × 100%

Evaluation:

• 10-year earnings growth > 33%

Criterion 6: Moderate P/E Ratio

Requirement: Current price not more than 15 times average earnings of the past three years

Rationale: Even good companies can be bad investments at high prices. A P/E of 15 limits overpaying risk.

Calculation:

3-year average EPS = (Year 1 EPS + Year 2 EPS + Year 3 EPS) / 3
Maximum price = 15 × 3-year average EPS

Evaluation:

• Current P/E (on 3-year average earnings) < 15

Criterion 7: Moderate Price-to-Book Ratio

Requirement: Current price not more than 1.5 times book value per share

Alternative: Product of P/E and P/B should not exceed 22.5

Rationale: Book value provides asset backing. Paying more than 1.5x book means you're paying significantly for intangibles, which increases risk.

Calculation:

Maximum price (P/B method) = 1.5 × Book value per share
Maximum price (product method) = √(22.5 × EPS × Book value)

Evaluation:

• P/B ratio < 1.5, OR
• P/E × P/B < 22.5

Workflow

Step 1: Gather and Review Inputs

Collect all relevant information:

• Review the provided data and context
• Identify key parameters and constraints
• Clarify any ambiguities or missing information
• Establish success criteria

Step 2: Analyze the Situation

Perform systematic analysis:

• Identify patterns and relationships
• Evaluate against established frameworks
• Consider multiple perspectives
• Document key findings

Step 3: Generate Recommendations

Create actionable outputs:

• Synthesize insights from analysis
• Prioritize recommendations by impact
• Ensure recommendations are specific and measurable
• Consider implementation feasibility

Output Format

## Defensive Investor Screening

### Company
[Name and brief description]

### Data Summary

| Metric | Value | Source |
|--------|-------|--------|
| Current Price | $XX | [Date] |
| Annual Revenue | $XX B | [Most recent year] |
| Current Assets | $XX B | [Balance sheet] |
| Current Liabilities | $XX B | [Balance sheet] |
| Long-Term Debt | $XX B | [Balance sheet] |
| Book Value/Share | $XX | [Calculated] |
| 10-Year Earnings History | [Summary] | [Income statements] |
| Dividend History | [XX years] | [Records] |
| 3-Year Average EPS | $XX | [Calculated] |

### Seven Criteria Evaluation

| # | Criterion | Requirement | Actual | Pass? |
|---|-----------|-------------|--------|-------|
| 1 | Adequate Size | Revenue > $500M | $XX B | [Pass/Fail] |
| 2 | Strong Financial Condition | CR > 2.0, LTD < WC | CR: X.X, LTD/WC: X.X | [Pass/Fail] |
| 3 | Earnings Stability | No losses in 10 years | [X years positive] | [Pass/Fail] |
| 4 | Dividend Record | 20+ years uninterrupted | [X years] | [Pass/Fail] |
| 5 | Earnings Growth | > 33% over 10 years | XX% | [Pass/Fail] |
| 6 | Moderate P/E | < 15 (on 3yr avg) | XX.X | [Pass/Fail] |
| 7 | Moderate P/B | < 1.5 or P/E×P/B < 22.5 | X.X or XX.X | [Pass/Fail] |

### Detailed Analysis

**Criterion 1: Adequate Size**
[Analysis and conclusion]

**Criterion 2: Strong Financial Condition**

Current Ratio = $XX B / $XX B = X.X Working Capital = $XX B - $XX B = $XX B Long-Term Debt vs. Working Capital: [Comparison]

[Analysis and conclusion]

**Criterion 3: Earnings Stability**
| Year | EPS | Profitable? |
|------|-----|-------------|
| [Year] | $X.XX | Yes/No |
[10 years of data]
[Analysis and conclusion]

**Criterion 4: Dividend Record**
[History summary and conclusion]

**Criterion 5: Earnings Growth**

Beginning 3-year average (Years 1-3): $X.XX Ending 3-year average (Years 8-10): $X.XX Growth: XX%

[Analysis and conclusion]

**Criterion 6: Moderate P/E Ratio**

3-year average EPS: $X.XX Current price: $XX P/E on 3-year average: XX.X Maximum allowed price at P/E 15: $XX

[Analysis and conclusion]

**Criterion 7: Moderate Price-to-Book**

Book value per share: $XX P/B ratio: X.X P/E × P/B: XX.X Graham Number: √(22.5 × $X.XX × $XX) = $XX

[Analysis and conclusion]

### Overall Assessment

**Criteria Met:** X of 7

| Status | Meaning |
|--------|---------|
| 7/7 | Fully qualifies for defensive portfolio |
| 5-6/7 | Near-defensive, minor concerns |
| 3-4/7 | Significant gaps, not suitable for defensive investor |
| 0-2/7 | Does not qualify - too speculative for defensive approach |

### Graham's Verdict

**If 7/7 Pass:**
"[Company] meets all seven criteria for a defensive investor. This is the type of substantial, well-established company with a demonstrated record of performance that Graham recommended. At current prices, it offers adequate safety for the conservative investor."

**If Some Failures:**
"[Company] fails [X] of Graham's seven criteria: [list failures]. While it may be suitable for an enterprising investor willing to do additional analysis, it does not meet the standards for a defensive portfolio. The defensive investor should look elsewhere."

### Price Guidance

| Price Level | P/E | P/B | Assessment |
|-------------|-----|-----|------------|
| Current: $XX | XX.X | X.X | [Current status] |
| Max defensive price: $XX | 15.0 | [calc] | Maximum for defensive investor |
| With margin of safety: $XX | 10.0 | 1.0 | Comfortable buy zone |

### Recommendation

[Clear guidance for the defensive investor]

Outputs

Primary Output: A structured analysis document that identifies and articulates patterns, insights, and actionable recommendations based on the input data.

Format:

## Analysis: [Topic]

### Key Findings
- [Finding 1]
- [Finding 2]
- [Finding 3]

### Recommendations
1. [Action 1]
2. [Action 2]
3. [Action 3]

Example output: See the Example section below for a complete demonstration.

Constraints

• Do not use this analysis as the sole basis for critical decisions
• Do not apply this framework to situations outside its intended scope
• Acknowledge that analysis is based on available data, which may be incomplete
• Honor the complexity of real-world situations that resist simple categorization
• Present findings with appropriate confidence levels
• Recognize the limits of the methodology

Example

Input: "Is Johnson & Johnson suitable for a defensive investor? Current price $155, revenue $95B, current ratio 1.2, 62 consecutive years of dividend increases, 10-year earnings growth 45%, 3-year average EPS $9.50, book value $45/share."

Output:

Defensive Investor Screening

Company

Johnson & Johnson (JNJ) - Diversified healthcare company with pharmaceuticals, medical devices, and consumer health segments.

Data Summary

Seven Criteria Evaluation

Detailed Analysis

Criterion 1: Adequate Size - PASS At $95 billion in annual revenue, JNJ vastly exceeds the $500 million threshold. This is one of the largest healthcare companies in the world.

Criterion 2: Strong Financial Condition - FAIL

Current Ratio = 1.2 (Requirement: > 2.0)

JNJ fails this criterion. A current ratio of 1.2 means current assets only cover current liabilities 1.2 times, not the 2x Graham required. This is common for modern well-managed companies that optimize working capital, but it doesn't meet Graham's conservative standard.

Criterion 3: Earnings Stability - PASS JNJ has been profitable every year for decades. No losses in the 10-year period examined.

Criterion 4: Dividend Record - PASS 62 consecutive years of dividend increases is exceptional. JNJ is a "Dividend King" - far exceeding Graham's 20-year requirement.

Criterion 5: Earnings Growth - PASS 45% growth over 10 years exceeds the 33% minimum. This represents approximately 3.8% annual compound growth.

Criterion 6: Moderate P/E Ratio - FAIL

3-year average EPS: $9.50
Current price: $155
P/E on 3-year average: 155 / 9.50 = 16.3
Maximum allowed price at P/E 15: $142.50

At 16.3x earnings, JNJ slightly exceeds Graham's P/E limit of 15.

Criterion 7: Moderate Price-to-Book - FAIL

Book value per share: $45
P/B ratio: 155 / 45 = 3.4 (Requirement: < 1.5)
P/E × P/B: 16.3 × 3.4 = 55.4 (Requirement: < 22.5)
Graham Number: √(22.5 × 9.50 × 45) = $98.23

JNJ significantly exceeds Graham's price-to-book limits by any measure.

Overall Assessment

Criteria Met: 4 of 7

JNJ is a high-quality company that fails Graham's defensive criteria primarily on valuation grounds. The business quality is excellent, but at current prices, Graham would consider it too expensive for a defensive investor.

Graham's Verdict

Johnson & Johnson fails 3 of Graham's seven criteria: financial condition (current ratio), P/E ratio, and price-to-book ratio.

The irony is revealing: JNJ's premium valuation reflects its quality - exactly the kind of company everyone wants to own, which is why it's expensive. But Graham's discipline reminds us that "a great company is not a great investment if you pay too much for the stock."

The defensive investor seeking strict Graham criteria should wait for a better price or look at less celebrated alternatives.

Price Guidance

Recommendation

JNJ is an excellent company that does not currently meet Graham's defensive investor criteria. Options:

1. Wait for lower prices. Market corrections occasionally bring quality names into Graham territory.
2. Accept higher standards. Modern interpretation might relax P/B requirement for asset-light businesses.
3. Look elsewhere. Other healthcare companies may meet all seven criteria.
4. Upgrade to enterprising approach. If you're willing to do more analysis, JNJ may be acceptable despite failing some criteria.

For the strictly defensive investor following Graham's original criteria: pass at current prices.

Integration

This skill is part of the Benjamin Graham expert persona. Use it to build portfolios of substantial, reasonably-priced companies suitable for the conservative investor.