Value investing is an approach
that is widely used today by individual investors and portfolio
managers. But the approach was originally formulated some 60 years
ago with the publishing of Graham and Dodd's college textbook
"Security Analysis." Benjamin Graham is properly credited as one of
the "fathers" of value investing. And reviewing the philosophy of
the originators can often prove enlightening.
Graham's approach focuses on the concept of an intrinsic value that
is justified by a firm's assets, earnings, dividends, and financial
strength. Focusing on this value, he felt, would prevent an investor
from being misled by the misjudgments often made by the market
during periods of deep pessimism or euphoria.
For investors to have a reasonable chance of better than average
results, they must follow policies that are inherently sound and
promising, yet different from the policies followed by most
investors or speculators. Graham warned that buying a neglected, and
therefore undervalued, security for profit generally proves to be a
protracted and patience-trying experience. However, the possibility
of extraordinary gains only exists when the investor disagrees with
market.
Graham's analysis of stocks was
framed by the construction and balance of a stock and bond
portfolio. A neutral portfolio position would have half of the
portfolio in stocks and half in bonds. The proportion could
fluctuate from a minimum position of 25% to a maximum position of
75% depending upon the attractiveness of stocks relative to bonds.
Graham outlined his philosophy for the lay investor in his book "The
Intelligent Investor," first written in 1947 and updated
periodically.
Value Stocks: The Philosophy
Graham felt that it would be difficult for investors to "beat the
market," that is, to find stocks that will do much better than the
overall long-term market average. Stocks that will do better than
average over the long term are those with greater growth, but the
difficulty is finding those in advance.
The problem for investors, he reasoned, is twofold. First, even
stocks with obvious growth prospects don't necessarily translate
into extra profits for an investor because those prospects are
incorporated into the price of the stock.
Second, there is the risk that the investor will be wrong about the
firm's growth prospects. Graham felt that this risk is accentuated
by the psychology of the stock market, where the "tides of pessimism
and euphoria which sweep the market" could mislead investors into
overvaluing or undervaluing a stock.
In short, over the long term most investors can only expect an
average return, but there is the added risk of under performance due
to misjudgment.
Instead of seeking a way to produce above-average returns, Graham
proposed a method to reduce the risk of misjudgment. He suggested
that investors first determine an "intrinsic" value for a stock that
is independent of the market. Graham never fully explained how to
determine "intrinsic" value and admitted that it requires
considerable investment judgment. However, he felt that a firm's
tangible assets were a particularly important component; other
factors included earnings, dividends, financial strength, and
stability. Graham felt investors should limit their purchases to
stocks selling not far above this value, while stocks selling below
their intrinsic value would offer an even better margin of safety to
investors.
Graham felt investors should view themselves as the owners of a
business, with the goal of buying a sound and expanding business at
a rational price, regardless of what the stock market might say. And
a successful investment, he said, is a result of the dividends
produced and the long-range trend of the average market value of the
stock.
Types of Investors
Graham felt that individual investors fell into two camps:
"defensive" investors and "aggressive" or "enterprising" investors.
These two groups are distinguished not by the amount of risk they
are willing to take, but rather by the amount of "intelligent
effort" they are "willing and able to bring to bear on the task."
Thus, for instance, he included in the defensive investor category
professionals (his example--a doctor) unable to devote much time to
the process and young investors (his example--a sharp young
executive interested in finance) who are as-yet unfamiliar and
inexperienced with investing.
Graham felt that the defensive investor should confine his holdings
to the shares of important companies with a long record of
profitable operations and that are in strong financial condition. By
"important," he meant one of substantial size and with a leading
position in the industry, ranking among the first quarter or first
third in size within its industry group.
Aggressive investors, Graham felt, could expand their universe
substantially, but purchases should be attractively priced as
established by intelligent analysis. He also suggested that
aggressive investors avoid new issues.
Value Stock Criteria for Defensive Investors
In establishing a course of action for the defensive investor,
Graham laid out a set of criteria that would help the investor
obtain securities which offered a minimum level of quality in terms
of past performance and current financial position as well as a
minimum level of quality in terms of earnings and assets per dollar
of share price. Graham's analysis for the defensive investor
is divided into primary industry sectors. Graham presented an
investment approach specifically for utilities and industrials, but
said additional sectors such as financials should also be selected
using these criteria.
Rules for defensive investors:
ADEQUATE SIZE OF ENTERPRISE: Graham had a preference for large
companies. He felt that large firms have the resources in "capital
and brain power" to carry them through adversity and back to a level
of satisfactory earnings. This concern came into play for Graham
because he looked at stocks of firms that became unpopular due to
unsatisfactory developments of a temporary nature. Graham also felt
that the market responds more quickly with a price increase when an
improvement is shown for a large firm than a small firm.
When screening for company size, the three most popular criteria are
market capitalization (number of shares out-standing times market
price), sales, and total assets. Graham focused on sales for
industrials and total assets for utilities because they reflect
company activities and size directly, while market capitalization is
tied to overall market levels.
Graham specified that the defensive investor should exclude small
companies with less than $100 million of annual sales for industrial
companies and $50 million in total assets for public utilities.
Graham specified these levels over 20 years ago. Assuming a 5%
annual growth in prices over the last 25 years, our minimums would
increase from $100 million in sales to $340 million for industrials
and from $50 million in total assets to $170 million for utilities.
This screen is much more restrictive for non-utilities than
utilities. Except for small water and gas utilities, the capital
requirements for an utility are significant, along with the benefits
of economies of scale.
STRONG FINANCIAL CONDITION: Graham used different measures of
financial strength depending upon the industry. As a test of
short-term liquidity, Graham specified a current ratio (current
assets divided by current liabilities) of 2.0 or higher for
industrial firms. No current ratio requirement was specified for the
utility sector. Graham stated that this "working capital [current
assets minus current liabilities] factor takes care of itself in
this industry as part of the continuous financing of its growth by
sales of bonds and shares."
To measure the use of long-term debt, Graham required that long-term
debt for industrial firms not exceed net current assets, or working
capital. This is not a common ratio for screening programs, but if
your screening program allows you to create custom fields it should
be easy to duplicate. Take care that when using this criterion you
specify not only a upper limit, but a lower limit as well. If a
company's current liabilities exceed its current assets then it will
have a working capital deficit and a negative ratio of long-term
debt to net current assets. We specified that this ratio be positive
and less than or equal to 1.0.
If you are doing this on your own and your screening program does
not allow you to create custom fields you can use another measure of
financial leverage such as debt-to-equity or debt to assets.
Graham's criterion of debt to working capital screened out about
half the companies when used by itself, so look for a similar pass
rate.
Financing is an important consideration for utilities, so Graham
specified that investors look at the debt-to-equity ratio for this
sector. He specified that debt should not exceed twice the stock
equity (at book value, not market value). This turned out be a much
less restrictive screen than the financial condition screens for
non-utilities.
EARNINGS STABILITY: Graham liked to look at the historical company
performance over an extended period of time. He had a preference for
companies that avoided losses during recessionary periods. This
would point to industries such as utilities, insurance, food
processing, medical supply firms, and pharmaceuticals. Graham
recommended 10 years of positive earnings in his screen for the
defensive investors. Unfortunately, most screening programs on the
market today do not provide ten years of income statement data. Our
screen specifies that earnings be positive for only the last seven
years. To be true to Graham's original criteria, an investor would
want to see how the company performed over at least a complete
economic cycle when selecting the final candidates for the
portfolio.
STRONG DIVIDEND RECORD: A common test for financial strength over
time is a long period of uninterrupted dividends. In the defensive
investor screen, Graham recommended uninterrupted payments of at
least the past 20 years. In screening for the dividend record we
came across the same time limitation that we encountered with the
earnings screen--only seven years of data. For the non-utilities,
this criterion turned out to be a more restrictive screen than the
earnings screen. But the reason is not due to companies cutting
their dividends as much as it is a reflection that dividend payouts
have become less important and are not demanded by investors as
much. Today, companies are more inclined to use excess cash to buy
back their shares. To be faithful to Graham's original criterion,
publications such as the S&P Stock Guide and Moody's Dividend Record
report the record of uninterrupted dividends for a wide range of
companies.
EARNINGS GROWTH: Graham recommended a minimum increase of at least
one-third in per share earnings in the past 10 years, which
translates into about a 3% annual growth rate--a rate that roughly
keeps pace with inflation over the long term. With-out such a
criterion, a screen looking for companies with low multiples may
list companies with poor prospects. While Graham felt that even
companies in a state of "retrogression" could be of interest if they
could be purchased at a low enough price, this was not the do-main
of the defensive investor. Our filter specified a five-year growth
rate in earnings greater than 3%.
MODERATE PRICE-TO-EARNINGS RATIO: Graham seemed to express
frustration with the impact of special charges on the earnings per
share calculation. He felt that management's discretion in
establishing reserve accounts makes it difficult for the investor to
determine whether they truly reflect the operation of the firm for a
specific time period. To help get around this problem and to smooth
the impact of the business cycle, Graham often averaged earnings
over a period of several years. In specifying the price-earnings
filter, Graham required that the price to average earnings over the
last three years be no more than 15. His goal in establishing the
cut-off was to produce a portfolio with an average multiplier of 12
to 13. Graham wanted to establish a portfolio that was priced
reasonably compared to the yield available to the AA bond yield. At
the time he wrote the book, investment-grade bonds were yielding
7.5%. The inverse of this yield (1 divided by 0.075), 13.3,
determines the overall portfolio price-earnings ratio objective. If
bond yields go up, an investor would require that the price-earnings
ratio be lower to consider purchase of stocks. Conversely, lower
yields result in a higher price-earnings cut-off, which makes more
stocks available for consideration.
MODERATE PRICE-TO-BOOK-VALUE RATIO: Graham was a believer in using
low price-to-book-value ratios to select stocks and normally
required a ratio below 1.5 for the defensive investor. However, he
also felt that a low price-earnings ratio could justify a higher
price-to-book-value ratio. Therefore, he recommended that investors
multiply the price-earnings ratio by the price-to-book- value ratio
and not let that value exceed 22.5--the product of a current
price-earnings ratio of 15 and a price-to-book-value ratio of 1.5.
Graham noted that a price-earnings ratio below 15 could justify a
higher price-to-book-value ratio. As a rule of thumb, he proposed
that the product of two should not exceed 22.5. For instance, an
issue selling at 2.25 times book value could be justified if it were
selling at 10 times earnings (10 times 2.25 = 22.5).
At the time he was writing, Graham viewed utilities as particularly
attractive for defensive investors, which is why the criteria
include adjustments specifically for utilities. Graham felt these
firms fulfilled his criteria well and were selling at particularly
attractive prices at the time.
Graham certainly intended to skew a defensive investor's portfolio
away from "growth" stocks, which he viewed as more likely to be
overvalued and risky, and in today's environment, these criteria
will continue to exclude these kinds of firms. However, investors
should be aware of this tendency when employing this approach. In
addition, because of the emphasis on book value, which excludes
intangibles, the criteria will tend to exclude firms that have
considerable assets in the form of goodwill, patents, software,
franchises, etc. In particular, this would include firms that are
service-oriented, and those that are in the computer and technology
sectors, areas of the market that have become much larger and more
important than in Graham's day.
Stock Monitoring and When to Sell
Graham was a strong believer in defensive investing and protecting a
portfolio against errors in judgment. For that reason, he placed a
heavy emphasis on diversification. He recommended that individuals
purchase a minimum of 10 different issues and a maximum of 30.
Stock holdings should be reviewed at least annually, he said, paying
attention to dividend returns and the operating results of the
company, and ignoring share price fluctuations. However, if the
holdings were properly valued originally, he felt there would be
little need for changes.
Graham felt that as long as the earnings power of the holdings
remained satisfactory, the investor should stick with the stock and
ignore any market movements, particularly on the downside. On the
other hand, investors should take advantage of market fluctuations
on the upside, when a stock becomes overvalued (or fairly valued for
stocks that were purchased at below their intrinsic value); at these
times, investors should sell and replace their holding with one that
is more fairly valued or undervalued.
Graham in Summary
Graham's emphasis on tangible assets may need modifications for
current use in light of the many companies whose lines of business
depend heavily on intangibles. But his concern with value relative
to price maintains its relevance.
Graham summarized his own philosophy by stating that intelligent
investing consists of analyzing potential purchases according to
sound business principles. This includes: an understanding of what
you are doing, making your own decisions, ensuring that you are not
risking a substantial portion of your original investment, and
sticking to your own judgments without regard to market opinion.
"You are neither right nor wrong because the crowd disagrees with
you," he said. "You are right because your data and reasoning are
right. In the world of securities, courage becomes the supreme
virtue after adequate knowledge and a tested judgment are at hand."
For our screen, as of 1/2/08, earnings and dividend payout
requirements were relaxed from each of the past 7 years to each of
the past 3 years. A requirement was added to include only those
stocks that have increased in price over the past quarter and are
within 10% of their 52 week highs. Stocks are sold when the PE
exceeds 20 or when the PE times the price to book exceeds 30.
Information is provided by the American
Association of Individual Investors.
