I like things simple; I want to know within a reasonable amount of time if a stock is right for me. By narrowing our initial search to a few checks and balances we can prevent spending countless hours on researching a stock that in the end does not meet our tolerances for a sound investment.
In the fifth chapter of The Intelligent Investors Benjamin Graham sets four simple criteria for a conservative foundation to picking the common stock component of our portfolio.
- There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.
- Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear. Observations on this point are added at the end of the chapter.
- Each company should have a long record of continuous dividend payments. To be specific on this point we would suggest the requirement of continuous dividend payments beginning at least in 1950. (From 1973)
- The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period.
While no one set of rules fits all investors, it is good to have a foundation of which to compare different companies.
We are going to look at Marathon Petroleum Corporation (NYSE:MPC) and run it through the above steps.
1. Marathon Petroleum Corporation engages in refining, transporting and the marketing of petroleum products, mainly in the mid-west and southern United States. Marathon Petroleum split from its parent company Marathon Oil (NYSE:MRO) in 2011. Marathon Petroleum is a part of the Energy sector.
2. Graham's conditions for being a conservatively financed company are just that, conservative. When applying how stringent Graham's parameters are, only a small handful of companies are picked. The point of this is to ensure that the company we add to our portfolio has enough assets to avoid bankruptcy if the economy turns south.
3. In an attempt to simplify and save time we are going to look at total assets vs. liabilities. We are looking for at least twice as many assets as liabilities or 200%. As of the first quarter 2013 Marathon has $30,773,000,000 in assets and $18,773,000,000 in liabilities. The assets are 164% of liabilities.
Graham wanted to see at least 20 years of paying consecutive dividends. Marathon has been consecutively paid a dividend since its split up in 2011. Currently Marathon Petroleum has a payout ratio of 13%.
4. A P/E of 20 at the current EPS of $10.39 is $207.80 a share. The earnings for the past seven years are as follows:
As the data does not show seven years of earnings it is difficult to properly assess this valuation. Based on dividing the past five years of earnings by as many years we get an average EPS of $4.60. At a P/E of 25 we get a price of $115. However, there is an error as Graham set the 25 P/E for seven years not five. Based on an average EPS for the past seven years we get $3.28 a share and at a P/E of 25 we get a price point of $82.00 a share. This is also not a fair calculation as two of the years represent no earnings. We do receive a range valuation from $82.00 to $115.00 based on this metric.
Graham set some stringent guidelines when selecting stocks. When we look at the framework constructed by investing legends it is a good practice to take what they have developed and adjust it to fit our needs and goals. Graham set the foundation of value investing. The framework he developed is still a great way to look at stocks in today's market.
Simply because a stock does or does not pass a rule set up by someone else does not mean you should or should not start a position in it. In the case of Marathon Petroleum Company we find a rare case that hinders our ability to place a proper value on past performance. However, from the data we do have, we know that the liabilities are too high for Graham. There is a short history of dividends but with a low payout, which could suggest further dividends in the future. Also we have a range in price. Because the ttm value is less than the past multi-year valuation we can conservatively conclude that based on growth of the past few years the stock is undervalued.
Because of the debts to liabilities calculation Graham would consider this company too risky. However, I found it interesting. After further research I decided to take a position in the company. What really struck me was the 2012 annual report, which I recommend when looking at stocks.
A little something else I noticed, when you go to the company web page for Marathon Petroleum, the third button to click on at the top of the home page is "Investor Center", simple. I found this interesting as the investor directory is usually at the bottom of the page and takes a few seconds to locate.
Disclosure: I am long IBM, KO, MPC, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.