Graham's other great organising idea is that there's no single "right" way to invest. There are two legitimate archetypes, and the fatal error is wanting the returns of one while doing the work of the other.
What are Graham's criteria for a defensive investor?
The defensive (passive) investor wants safety, freedom from effort and worry, and a decent but unspectacular return. Graham prescribes a set of conservative rules that need little ongoing judgement. Here are his criteria for defensive common-stock selection from Chapter 14, adapted:
- Adequate size. Avoid the smallest, most fragile companies. In his day that meant a minimum revenue threshold. The spirit is to stick with the established and steer clear of the speculative.
- Strong financial condition. Current ratio ≥ 2, and long-term debt no greater than working capital. Survivability comes first.
- Earnings stability. Positive earnings in each of the last 10 years. No recent losses.
- Dividend record. Uninterrupted dividends for 20 years. A long promise kept.
- Earnings growth. At least ~⅓ growth in per-share earnings over 10 years, using 3-year averages at each end to smooth it. Modest and proven, never heroic.
- Moderate P/E. Price no more than ~15× average earnings of the last 3 years.
- Moderate P/B. Price no more than ~1.5× book value. Or use the combined test, P/E × P/B ≤ ~22.5, which allows a higher multiple only if book value backs it.
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Do Graham's criteria still work today?
Don't memorise the thresholds as gospel. They're calibrated to 1970s US markets. Applied literally today, especially the 1.5× P/B and 15× P/E, they'd exclude nearly every quality business the rest of the course teaches you to admire. Nestlé India at ~1.5× book is unimaginable. Memorise the architecture instead. The defensive investor buys established, financially strong, consistently profitable, dividend-paying companies at undemanding multiples, in a diversified list, and then mostly leaves them alone. It's a rules-based margin of safety for someone who won't do deep work, and for most people in the world it's still close to the correct strategy. A low-cost index fund may well be the modern, purer form of Graham's defensive portfolio, and the active-versus-passive debate in the portfolio phase takes that question up evenhandedly.
What does an enterprising investor do?
The enterprising (active) investor is willing to put substantial time, effort and independent judgement into chasing a better-than-average return. Graham doesn't promise it pays off. His sober warning is that the enterprising investor has to clear a high bar of skill and self-control just to justify the effort, and that most who try would do better as defensive investors. The enterprising investor earns a premium by doing the work the defensive one won't. That means buying relatively unpopular large companies (out-of-favour blue chips), hunting bargains such as net-nets and other sub-intrinsic-value situations, and pursuing special situations (workouts, arbitrage, distress), which is Greenblatt's territory. Everything after Phase 0 trains you for the enterprising path, and you chose that path when you chose to study here. But Graham's humility is a permanent guardrail. The enterprising path is justified only if your work actually produces an edge. Otherwise you're paying the costs of activity (time, taxes, friction, mistakes) to underperform the defensive investor you could have been. Phase 9's calibration work is there to keep you truthful about whether your enterprise is earning its keep.
In the elective on market-level valuation and the index default, the defensive archetype turns from something you admire into a written policy. It carries Graham's never-below-25-percent and never-above-75-percent allocation band, the rebalancing trades the band forces, and the index default stated with its arithmetic.