Graham's Stock Selection Criteria Revisited

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Includes: AXP, BA, CAT, CSCO, CVX, DD, DIS, GE, GS, HD, IBM, INTC, JNJ, JPM, KO, MCD, MMM, MRK, MSFT, NKE, PFE, PG, T, TRV, UNH, UTX, V, VZ, WMT, XOM
by: Difu Wu

Summary

Ben Graham's stock selection criteria are tried and true for the defensive investor.

The Dow Jones Industrial Average (DJIA) today is overpriced and has relatively weak financial condition, thereby no longer fulfilling criteria for defensive investing.

The defensive investor should look elsewhere, and wait for a correction before investing in the DJIA issues.

I have been re-reading Ben Graham's classic book The Intelligent Investor. In chapter 14 (2003 ed. of book originally published in 1973), he outlined 7 quality and quantity stock selection criteria for the defensive investor, which are worth revisiting:

Quality

1. Adequate Size of the Enterprise. He suggested at least $100 million of annual sales for an industrial company, and at least $50 million of assets for a public utility. Fast forward to the present (2014), we can adjust these 1973 number for inflation to roughly $500 million of annual sales and $250 million of assets. Some people use market cap as a proxy for size, but that confuses market valuation with business fundamentals. While the two are very much correlated, they may widely diverge at times, and paying exorbitant price for a small business is the exact opposite of defensive investing.

2. A Sufficiently Strong Financial Condition. Current ratio should be at least 2:1 for industrial companies; debt to equity should be no more than 2:1 for public utilities.

3. Earnings Stability. Some earnings in each of past ten years.

4. Dividend Record. Uninterrupted payments for at least the past 20 years.

5. Earnings Growth. A minimum of at least one-third in per-share earnings in the past ten years using three year averages at the beginning and the end. Multi-year average earnings smooth out cyclical earning variations and better reflect a company's true earning potential.

Quantity

6. Moderate Price/Earnings Ratio. Current price should be no more than 15 times average earnings of the past three years. Again, ignore single year earnings. P/E calculated using trailing twelve month earnings or predicted earnings for the next 12 months are unreliable.

7. Moderate Ratio of Price to Assets. Current price should be no more than 1.5 times the book value last reported. As a rule of thumb, the product of P/E and P/B should not exceed 22.5.

These are timeless criteria every defensive investor should bear in mind. By minding the downside, the upside will take care of itself. The 5 quality criteria helps to weed out businesses without economy of scale, those with too much debt or too little working capital, unprofitable companies, and those whose earnings fail to keep up with inflation. The two quantity criteria ensure that we do not overpay by providing a moderate margin of safety.

When Graham applied these criteria to the Dow Jones Industrial Average (DJIA) at the end of 1970, he found five of the 30 components meeting all 7 criteria. They were American Can, American Tel. & Tel., Anaconda, Swift, and Woolworth.

Application of Graham's Criteria to the DJIA at the end of 2014

How many of the 30 components of the DJIA meet these criteria today? The table below lists all the 30 DJIA stocks with the Graham criteria (red means it failed; green means it passed). These data are readily obtainable from SEC filings.

Stock

Ticker

Price

Sales

Current ratio

Earnings stability?

Yrs of Uninterrupted Dividends

2002-2004 Avg Earnings

2011-2013 Avg Earnings

Earnings Growth

Price to Earnings

Book value

Price to Book

(P/E)*(P/B)

# Criteria Met

3M

MMM

157.12

30871

1.65

Yes

97

2.91

6.33

117.53%

24.82

25.24

6.23

154.51

4

American Express

AXP

91

34932

1.27

Yes

144

2.33

4.3

84.55%

21.16

19.42

4.69

99.17

4

AT&T

T

32.16

128752

0.65

Yes

30

2.01

1.77

-11.94%

18.17

17.86

1.80

32.72

3

Boeing

BA

120.77

86623

1.26

Yes

72

1.27

5.47

330.71%

22.08

20.33

5.94

131.16

4

Caterpillar

CAT

90.5

14150

1.39

Yes

100

3.73

7.21

93.30%

12.55

31.09

2.91

36.54

5

Chevron

CVX

102.38

220156

1.27

Yes

102

3.43

12.62

267.93%

8.11

82.6

1.24

10.06

6

Cisco Systems

CSCO

26.85

47142

3.31

Yes

3

0.66

1.61

143.94%

16.68

11.1

2.42

40.34

4

Coca-Cola

KO

40.91

46854

1.08

Yes

121

1.79

1.91

6.70%

21.42

7.64

5.35

114.69

3

DuPont

DD

69.35

35734

1.74

Yes

110

0.54

3.95

631.48%

17.56

17.32

4.00

70.30

4

ExxonMobil

XOM

86.6

420836

0.89

Yes

103

2.93

8.5

190.10%

10.19

42.65

2.03

20.69

5

General Electric

GE

24.89

146045

2.02

Yes

121

1.5

1.26

-16.00%

19.75

13.44

1.85

36.58

4

Goldman Sachs

GS

188.82

34206

0.38

Yes

15

6.27

11.37

81.34%

16.61

161.38

1.17

19.43

4

IBM

IBM

155.38

99751

1.11

Yes

101

3.77

14.12

274.54%

11.00

14.4

10.79

118.74

5

Intel

INTC

36.22

52708

1.85

Yes

22

0.82

2.14

160.98%

16.93

11.55

3.14

53.08

4

Johnson & Johnson

JNJ

104.43

71312

2.61

Yes

70

2.47

4.05

63.97%

25.79

27.31

3.82

98.60

5

JPMorgan Chase

JPM

60.04

96606

1.39

Yes

187

1.86

4.68

151.61%

12.83

41.13

1.46

18.73

6

McDonalds

MCD

90.62

28106

1.25

Yes

38

1.21

5.39

345.45%

16.81

14

6.47

108.83

4

Merck

MRK

57.72

44033

1.34

Yes

44

2.93

1.83

-37.54%

31.54

15.68

3.68

116.11

3

Microsoft

MSFT

46.95

86833

2.52

Yes

11

0.85

2.4

182.35%

19.56

10.92

4.30

84.11

4

Nike

NKE

96.17

27799

2.81

Yes

30

0.85

2.68

215.29%

35.88

12.85

7.48

268.56

5

Pfizer

PFE

30.95

51584

2.86

Yes

113

1.16

2.13

83.62%

14.53

12.29

2.52

36.59

6

Procter & Gamble

PG

89.55

83062

0.91

Yes

124

2.28

3.84

68.42%

23.32

24.04

3.73

86.87

4

The Home Depot

HD

99.78

78812

1.37

Yes

27

1.9

3.08

62.11%

32.40

7.67

13.01

421.45

4

Travelers

TRV

103.16

26191

1.32

Yes

27

1.75

6.47

269.71%

15.94

76.41

1.35

21.53

5

United Technologies

UTX

112.15

62626

1.23

Yes

78

2.44

5.8

137.70%

19.34

37.35

3.00

58.06

4

UnitedHealth Group

UNH

98.76

122489

0.74

Yes

24

1.51

5.17

242.38%

19.10

33.56

2.94

56.21

4

Verizon

VZ

45.58

120550

0.92

Yes

31

1.8

1.72

-4.44%

26.50

3.99

11.42

302.72

3

Visa

V

256.78

12702

3.46

No

6

-0.52

6.46

-1342.31%

39.75

43.99

5.84

232.03

2

Wal-Mart

WMT

83.81

476294

0.92

Yes

41

2.09

4.81

130.14%

17.42

24.55

3.41

59.48

4

Walt Disney

DIS

91.49

48813

1.14

Yes

32

0.99

3.59

262.63%

25.48

26.19

3.49

89.03

4

DJIA

94552

1.56

Yes

67

106.21%

20.44

4.38

99.90

4

None of these 30 prominent stocks meet all 7 criteria. Chevron, JPMorgan Chase, and Pfizer came close, each meeting 6 of 7 criteria.

The DJIA today appears to be poorer in both quality and quantity compared to the DJIA at the end of 1970. All 7 criteria were satisfied by the DJIA in aggregate at the end of 1970, but only 4 are satisfied today. The three that it failed are sufficiently strong financial condition, moderate price to earnings ratio, and moderate price to assets ratio. The DJIA issues in 2014 appear more aggressive in their finances. At the same time, these issues are amply priced by the market, diminishing prospects of future return when bought at the current price. The product of P/E and P/B for the DJIA today is 99.9, which is more than four times Graham's recommended 22.5.

A few aspects remain constant for the DJIA in 2014 versus 1970:

1. Size is more than adequate, with all 30 issues far exceeding the stipulated $500 MM in annual sales.

2. Most of the 30 issues have long history of uninterrupted dividends, with 11 of them going back over 100 years. The average DJIA stock boasts a history of 67 years of uninterrupted dividends. Only 4 issues failed the dividend criterion.

3. The aggregate earnings have been quite stable in the past decade. Except for Visa, which posted deficits in 2007 and 2003, none of the issues reported a deficit during the past 10 years. Similarly, 29 of 30 issues had no deficits in each of past 10 years for the DJIA in 1970.

4. The total earnings per share growth, comparing three-year averages a decade apart, was 106% for the aggregate, or about 7.5% per year. This compares with 77% for the DJIA in 1970.

The major differences:

1. Financial condition. The DJIA today has a current ratio of only 1.56, short of 2:1, which was met by the DJIA in 1970. This proved to be the most stringent criterion, with only 7 issues passing the test.

2. Ratio of price to three-year average earnings was 20.44 for the DJIA today, compared to 15 for the DJIA in 1970.

3. Ratio of price to net asset value was 4.38 for the DJIA today, compared to 1.49 for the DJIA in 1970.

In sum, the DJIA today is significantly overvalued and less financially sound. The solution for the defensive investor is not to relax his criteria, as many are wont to do during periods of bull market optimism, but to look beyond these 30 prominent DJIA issues. That said, most of these issues remain high quality, with 3 meeting all 5 quality criteria (they are Johnson & Johnson, Nike, and Pfizer), and would be suitable for investment after a correction.

Disclosure: The author is long T, KO, XOM, IBM, INTC, JNJ, MCD, MRK, MSFT, NKE, PG, WMT.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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