Would Benjamin Graham Like HollyFrontier?

May.28.13 | About: HollyFrontier Corp. (HFC)

Benjamin Graham is the godfather of value investing and was Warren Buffett's mentor. As he is regularly cited as the reason for Buffett's success, many people try to mimic his investing style, which is set out in his book The Intelligent Investor.

But unfortunately, with so many trying to copy his techniques, many have misread facts, often looking for quick fixes to beat the market and get ahead of the game. It is not that simple.

Ben Graham's criteria

These are the original criteria that Graham set out in his book in order to find securities that are suitable for the defensive investor.

1. Adequate size of enterprise

$100 million ($360 million at least, adjusted for inflation) annual sales for industrial company; $50 million for public utility ($180 million, adjusted for inflation).

2. Sufficiently strong financial position

Current ratio of no less than 2.

3. Long-term debt should not exceed net current assets (working capital)

Utilities debt should not exceed twice the stock equity

4. Earnings stability

Some earnings for the common stock in each of the past 10 years

5. Dividend record

Uninterrupted payments for 20 years

6. Earnings growth

A minimum of 30% increase in earnings over 10 years (with beginning and end values taken as averages over three years)

7. Moderate P/E ratio

No more than a P/E of 15 of average earnings over the past three years

8. Moderate ratio of price to assets

Book value should be no more than 1.5 times

The criteria are very strict and many investors nowadays do not bother to conduct such in-depth analysis when considering a prospective investment.

It is also useful to note that Graham uses three-year averages when evaluating a company on its P/E ratio, which helps to smooth out any one-off items that could cause the P/E to give an abnormally high or low figure for the year in question.

Pickings are slim in the market currently for an investment that meets all of Graham's criteria, however, HollyFrontier (HFC) currently looks as if it could be a potential candidate. So how does it stack up against the strict criteria above?

Adequate size of enterprise

2008

2009

2010

2011

2012

Sales ($US Millions)

$5,870

$4,830

$8,320

$15,440

$20,190

Click to enlarge

HollyFrontier's sales have exceeded $1 billion for the past years, easily passing the first test.

Sufficiently strong financial position

2011

2012

Current Assets

$4,660

$4,470

Current Liabilities

$2,630

$1,650

Current Ratio

1.8

2.7

Click to enlarge

Current assets covered current liabilities 2.7 times during 2012, putting HollyFrontier in a stable financial position. However, the company did not have the same kind of financial stability during 2011. Although, as we only concerned with the most recent year, 2011's figures are not currently relevant.

Long-term debt should not exceed net current assets (working capital)

Metric 2011 2012
Net Current Assets $2,030 $2,820
Debt $1,210 $1,340
Cover 1.7x 2.1x
Click to enlarge

Net current assets easily cover HollyFrontier's low level of debt.

Earnings stability

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

EPS

$0.23

$0.65

$1.35

$2.29

$2.99

$1.19

$0.2

$0.97

$6.42

$8.38

Click to enlarge

Furthermore, HollyFrontier has produced some earnings in each year for the past nine. However, my data does not extend back to 2002 but barring a serious set-back this year, the company should continue to be profitable, which will be ten years of positive earnings.

Dividend Record

This is the only criteria where HollyFrontier falls down as my data only extends back ten years. Graham requires dividend payments extending back twenty years. So, while it is not possible to prove the company has paid a dividend for twenty years, I can prove it has issued a dividend payout for ten. As the company already meets the criteria set out above, this rule can be bent slightly.

Earnings Growth

2003-2005 Average

2010-2012 Average

Growth

EPS

$0.74

$5.3

616%

Click to enlarge

HollyFrontier's earnings have grown 616% during the last ten years, with three year averages taken at the beginning and end of the period - Easily beating Graham's criteria for growth.

Moderate P/E ratio

2010-2012 Average EPS Current Price P/E
$5.3 $49.7 9.4
Click to enlarge

Currently, HollyFrontier's trailing-twelve-month P/E ratio, as quoted on financial websites, sits at 5.6, based on record earnings last year. However, using Graham's method of using an earnings figure that is calculated as a three-year average, HollyFrontier currently trade on a tty (trailing three year) P/E of 9.4, which is below Graham's requirement of 15.

Moderate ratio of price to assets

2012

Asset Value per Share

$30.9

Current Share Price

$49.7

P/B ratio

1.6

Click to enlarge

Meanwhile, HollyFrontier's price to book ratio is above the 1.5 required by Graham in order for the investment to be classified as a value investment. However, according to the 'Intelligent Investor' it is possible for a company to have a P/B ratio greater than 1.5 as long as is combined P/E and P/B ratio do not exceed 22.5.

To define this further, the formula below is used.

Graham Number

The Graham number is a method of estimating the fair value of a stock based on its earnings-per-share and asset value per share. If the answer is above (below) the current share price then the stock is undervalued (overvalued).

With a Graham Number of $76.3, HollyFrontier appears undervalued.

Conclusion

Overall, HollyFrontier meets all the criteria for a Benjamin Graham investment. The company stumbles slightly on its dividend history but it meets all the other criteria and currently appears undervalued.

Disclosure: I am long HFC. 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.