Warren Buffett is possibly the world's most successful investor, and is known for his proficiency with stocks. Benjamin Graham was Warren Buffett's professor and mentor at Columbia Business School. In this article, we'll also look at how Graham's teachings on stock selection can be applied - as faithfully as possible - to today's stock markets using modern technology, allowing us to invest safely and successfully.
How Do Stocks Grow
The central underlying principle of Graham's methods is that stocks are fractional ownerships of corporations, and that there can be large differences between the underlying worth of a stock and the price quoted for it. So if a stock is chosen correctly, one's investment will grow as the stock price corrects itself, and also as the company grows. The challenge for investors is finding the right companies at the right price.
Stocks also have many advantages over other investments. They have more liquidity, they are naturally hedged (protected) against inflation, and most importantly, they have historically beaten all other forms of investment.
Evaluating Stocks - The Quantitative Measures
The first numbers Graham recommended looking at when evaluating a stock are its Earnings Per Share [EPS] and Book Value Per Share [BVPS]. If you were buying groceries, EPS and BVPS are similar to weight, or quantity.
Earnings Per Share:
EPS tells you how much profit that company makes per share.
EPS and Price are usually mentioned together as the Price-to-Earnings ratio, and give you a rough idea of what rate of return you can expect on your investment
Book Value Per Share:
BVPS is the theoretical liquidation value of the stock.
It's important to exclude things like Goodwill and other Intangibles - which have no real resale value - and use only tangible book values when evaluating stocks.
Evaluating Stocks - The Qualitative Measures
When buying something, we also need to look at "how good" it is, and not just "how much" we're getting. Graham recommended three different qualitative categories of stocks, and different quantitative requirements for each of them.
First Quality - Defensive Stocks:
The safest qualitative category of stocks recommended by Graham are called Defensive stocks. The criteria that Graham specified for identifying Defensive stocks are as follows:
Summarized from Chapter 14 of The Intelligent Investor - Stock Selection for the Defensive Investor:
1. Not less than $100 million of annual sales.
[Note: This works out to $500 million today based on the difference in CPI/Inflation from 1973]
2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past 10 years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past 10 years.
6. Current price should not be more than 15 times average earnings.
7. Current price should not be more than 1-1⁄2 times the book value.
As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.
Graham's recommended price for Defensive stocks can be calculated from criteria #6 and #7. This price is popularly known as the Graham Number.
Note that the Graham Number is designed to quantitatively assess any stock that meets the Defensive qualitative requirements, regardless of sector or industry.
For example, a public utility company that is typically low on Earnings will need a higher than average asset figure to justify its price. Similarly, a Financial Services company that is typically low on assets will need a higher than average Earnings figure to be an acceptable investment.
Graham recommended a minimum portfolio size of 10 for Defensive stocks, or in other words, not more than 10% of total investment per Defensive stock.
Second Quality - Enterprising Stocks:
For Enterprising investors who are looking for greater profits - and are willing to put in more effort into the maintenance of their portfolio - Graham then recommended the following criteria for identifying Enterprising quality stocks:
Summarized from Chapter 15 of The Intelligent Investor - Stock Selection for the Enterprising Investor:
[Note: For issues selling at P/E multipliers under 10]
1-A. Current assets at least 1 1⁄2 times current liabilities.
1-B. Debt not more than 110% of net current assets.
2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year's earnings more than those of 1966.
[Note: Corresponds to the earnings of 5 years ago]
5. Price: Less than 120% net tangible assets.
Thus, the price limit for a stock meeting Enterprising quality requirements is the lower of 120% net tangible assets (book value), or 10 times current earnings. We can combine the two - as Graham did for the Defensive Price - to yield a quantitative price calculation similar to the Graham Number. We'll call this the Serenity Number.
Just like the Graham Number, the Serenity Number too applies to any stock, regardless of sector or industry, because it's a combination of both Assets and Earnings. A lower value in one will have to be compensated for by a higher value in the other.
Serenity's recommendation is for a minimum portfolio size of 20 for Enterprising stocks, or in other words, not more than 5% of total investment per Enterprising stock.
Third Quality - NCAV Stocks or Net-Net Stocks:
For investors who were willing to put in the most effort into the maintenance of their portfolio, Graham finally recommended NCAV quality stocks, which he defined as:
Summarized from Chapter 15 of The Intelligent Investor - Stock Selection for the Enterprising Investor:
"Bargain Issues, or Net-Current-Asset Stocks"
"...price less than the applicable net current assets alone - after deducting all prior claims, and counting as zero the fixed and other assets."
"...eliminated those which had reported net losses in the last 12-month period."
These criteria give us stocks selling for less than the value of their cash worth alone, and with positive earnings in the last one year.
Since NCAV stocks are the least established of all stocks, they also require the most diversification. A portfolio of NCAV stocks will require at least 30 NCAV stocks, or not more than 3.3% of total investment per NCAV stock.
Getting Down to Business - Finding Graham Stocks Today
The good news is that today's technology makes it easy to find stocks that meet even such advanced criteria. Applying data-mining algorithms on Serenity's data warehouse of 5000 NYSE and NASDAQ stocks allows us to screen the entire stock market and filter out just the ones that meet the Graham criteria.
Few stocks meet all of Graham's Defensive criteria today. But it is also possible to find stocks that meet all the qualitative Defensive criteria, and part of the quantitative Defensive criteria. Both types are shown on The Benjamin Graham Stock Screener below.
The same screener can also be used for similar searches to find stocks meet Graham's Enterprising and NCAV criteria.
Stocks like Helmerich & Payne (HP) and HollyFrontier (HFC) that had previously been demonstrated by Serenity's screeners to be Defensive have now appreciated far beyond the Defensive Price (Graham Number).
Using the more customizable Graham-Number Stock Screener, we can also find stocks that meet different combinations of qualitative and quantitative criteria.
The Graham Number is essentially 137% of the Serenity Number. Basically - for a given EPS and BVPS - we pay 137% more for a Defensive stock since it is of higher quality than an Enterprising stock.
Thus the search for Enterprising stocks can be replicated (and customized) on The Graham-Number Screener using the following values:
Current Assets / Liabilities: 75%
Current Assets / Long-Term Debt: 90%
Earnings Stability: 50%
Dividend Record: 5%
Graham Number / Price: 137%
A Full Graham Analysis For Universal Corporation
To understand how a full Graham analysis works, let's take the example of Universal Corporation. In the Financial Condition tab for UVV on Serenity, we see the sales and balance sheet figures that were used in the qualitative analysis.
Annual Sales: $2,540.00 Million
Current Assets: $1,673.20 Million
Goodwill: $0.00 Million
Intangibles: $99.50 Million
Total Assets: $2,270.90 Million
Current Liabilities: $455.00 Million
Long Term Debt: $240.00 Million
Total Liabilities: $892.70 Million
Preferred Stock: $213.00 Million
Shares Outstanding: 23.22 Million
This data is used to calculate ratings like Assets / Liabilities, Assets / Debt etc., and the NCAV price. But most importantly, this data is used to calculate the Tangible Book Value. UVV has reported a Book Value of $50.19. But after deducting Goodwill and Intangibles from the Total Assets, we get a more accurate Book Value of $45.90.
This correction affects both the Defensive Price and the Enterprising Price, as well as the final quantitative result. So every stock on Serenity has both the Reported BVPS and Tangible BVPS displayed on it in the Per Share Value's tab as shown below. Only the Tangible Book Value is used for the Graham analysis.
Combining all the above data with UVV's dividend history, we get the following ratings for UVV for each of Graham's Defensive criteria:
Sales: 508.00% (2,540 / 500)
Assets / Liabilities: 183.87% (1,673.2 / 2x455)
Assets / Debt: 507.58% (1673.2 / 240)
Earnings Stability: 100.00% (10 years)
Dividend Record: 100.00% (20 years)
Earnings Growth: 147.07% (EPS-1 / 1.3xEPS-10)
Graham Number / Price: 135.98% ($73.63 / $54.15)
Shown below is the Final Graham Assessment tab for UVV which gives a summary of the entire analysis.
We see that UVV has a Defensive Price (Graham Number) of $73.63, an Enterprising Price (Serenity Number) of $53.77 and an NCAV Price of $24.44. We also see that the qualitative result for UVV is Defensive and thus, the Defensive Price (Graham Number) is also the Graham Price.
Finally, we see the last closing price of the stock ($54.15) and that UVV has a quantitative result of 100% (since the Graham Price is more than the last closing price). The quantitative result is capped at a maximum of 100% on Serenity to avoid differentiating between stocks that pass the quantitative criteria to different degrees.
Thus, not only do we get a meticulous Graham analysis for UVV, but also get to see all the data used for the analysis. So once a list of potential stocks for investment is shortlisted using the screeners, the figures used for analysis can be verified with the annual reports on the company websites.
In The Intelligent Investor, Graham says "Confronted with a [like] challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety." Almost everyone in the financial world will tell you that for better returns, you need to take greater risks. But Graham taught that an investor's returns depend on the amount of intelligent effort he was willing to put into his investments, and that increased risk actually reduces returns.
There are those who will say that Graham's principles are outdated, citing Globalization and Technology. But stocks like IBM have existed since Graham's time, and institutions like the World Bank and IMF were established early in the 19th century to regulate international trade. Stock markets have existed for nearly 400 years now; NYSE for 150 years. There really is nothing new under the sun. The proliferation of technology may have made stock markets more competitive, but the fundamental ways in which they work remain the same.
Warren Buffett's article The Superinvestors of Graham-and-Doddsville gives a detailed explanation of why Graham's principles are fundamental tenets, and why the world's most successful investors are Graham's students. A reading of both Buffett's article and The Intelligent Investor is strongly recommended for any aspiring investor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: These results were arrived at with data mining algorithms and were not verified manually. Please verify the research - especially for any recent stock splits - before making an investment decision.
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