Last month, I wrote an article highlighting 4 Quick Picks for the Benjamin Graham Defensive Investor. The article got a lot of positive feedback from the community, so I decided to start posting a monthly selection of stocks for the Benjamin Graham defensive investor along with a review of the previous selection's performance.
About Benjamin Graham and his Criteria for the Defensive Investor
For those unfamiliar, Benjamin Graham is best known for being the mentor to the second wealthiest individual in the U.S., Warren Buffett. Considered by many to be the "father of value investing", Graham wrote the book The Intelligent Investor (you can find it on Amazon here), which he describes the investment philosophy that his firm used to achieve annualized returns of about 20% from 1936 to 1956.
In chapter 14 of The Intelligent Investor, Graham outlines criteria for the defensive investor to select stocks. Graham considered a defensive investor to be someone who wanted a safe return without much bother. The seven criteria he outlined are as follows:
- Adequate Size of the Business - The intent of restricting size of the business is to prevent the defensive investor from smaller businesses that are more susceptible to the changes within the industry. Graham set arbitrary criteria in 1973 of $100M in annual sales for an industrial company and greater than $50M in total assets for a public utility. Accounting for inflation, the criteria in 2012 are approximately $500M in net sales for an industrial company and $250M in assets for a utility.
- Sufficiently Strong Financial Condition - There are two criteria to screen out companies of insufficient financial strength: (1) Industrial enterprises must have a current ratio, that is the ratio of current assets to current liabilities, greater than or equal to 2. (2) Industrial enterprises' long-term debt cannot exceed net current assets. If the enterprise is a public utility, the debt cannot exceed stock equity at book value.
- Earnings Stability - The Company must have some earnings in each of the last 10 years. A corollary to this is that no single year in the last 10 should contain an earnings deficit.
- Dividend Record - The company should have uninterrupted dividend payments for 20 years.
- Earnings Growth - Earnings must have increased by 33% in the past 10 years based on a three-year average at the beginning and end of the decade.
- Moderate Ratio of Price to Earnings - To eliminate the risk of a defensive investor overpaying for a good company, the current price should not be more than 15 times average earnings of the past three years.
- Moderate Ratio of Price to Assets - The current price should not be more than 1.5 times book value in the last year, unless the price/earnings ratio is less than 15. In such a case, a higher multiplier for price to assets maybe justifiable, but the product of price to earnings and price to assets should not exceed 22.5.
Review of Last Month's Picks
Those that read last month's article might recall the four recommended companies were Baker Hughes (NYSE:BHI), Cash America International (NYSE:CSH), Helmerich & Payne Inc. (NYSE:HP), and Holly Frontier Corporation (NYSE:HFC). Below summarizes the price of each equity on Jan. 1, 2013 when the article was published, the target price based on the Graham Number, the closing price on Feb. 1, 2013, and the percentage change in price.
Graham Number Price
The search in February yielded six companies that meet Graham's Defensive Investor criteria: Baker Hughes , Cash America International , Holly Frontier Corporation , Alamo Group (NYSE:ALG), Reliance Steel & Aluminum (NYSE:RS), and Sasol Ltd. (NYSE:SSL).
Ratio Current Assets to Long Term Debt3
Positive 10 Year Earnings4
Dividends Paid Since5
1 Data from Google Finance
2 Data from Yahoo Finance
3 Calculated based on data from http://www.gurufocus.com/
4 Data from MSN Finance
5 Data comes from: http://www.dividendinvestor.com/6 Calculated based on data from http://www.gurufocus.com/ by averaging the first three years of the decade and the last three years of the decade.
7 Calculated based on data from Yahoo Finance
The astute might be wondering why Helmerich & Payne Inc. was removed from the list. The reason I removed it from the list is that its current price is within just 2% of what the Graham Number estimates it to be worth, thereby no longer providing an opportunity to profit.
The first month of 2013 has to stocks picks using the criteria Benjamin Graham created for the defensive investor performing well, with the four picks averaging a return of 15.5% for the month. Three of the four companies selected in January remain on the list; Helmerich & Payne Inc. has been removed, since it has come within 2% of the Graham Number. Defensive investors still holding HP should sell.
New additions to the list include Alamo Group, Reliance Steel & Aluminum, and Sasol Ltd., which have upside potentials based on the difference in current price and the Graham Number estimate of 21%, 11%, and 200% respectively.
Look forward to comments below and make sure to follow so you get next month's update.