Ranked by 28-Period Williams %R as of 02/20/09 *

Key

Benjamin Graham Defensive Screening Criteria

Biographical Information

    Benjamin Graham is properly credited as one of the "fathers" of value investing. Graham's approach focuses on the concept of an intrinsic value that is justified by a firm's assets, earnings, dividends, and financial strength. Graham outlined his philosophy for the lay investor in his book "The Intelligent Investor," first written in 1947 and updated periodically.  Graham felt that individual investors fell into two camps: "defensive" investors (those having limited time to study the markets) and "aggressive" or "enterprising" investors ( those who have time to study).

Rules for defensive investors:

     Graham had a preference for large companies. 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.  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.

     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. 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. 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

     Graham had a preference for companies that avoided losses during recessionary periods, 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. This screen specifies that earnings be positive for only the last seven years. In the defensive investor screen, Graham recommended uninterrupted dividend payments of at least the past 20 years. 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.

     Graham recommended a minimum increase of at least a 3% annual growth rate--a rate that roughly keeps pace with inflation over the long term. This filter specifies a five-year growth rate in earnings greater than 3%.

     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.

     Graham required a price to book 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. 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.

    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. 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 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.