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Grahams approach focuses on determining the intrinsic value of a stock, which takes into consideration the rms earnings, tangible assets, dividends, nancial strength and stability. He believes investors should buy stocks whose prices are close to their intrinsic value, and preferably those that are priced lower than their intrinsic value. AAII developed several screens based on Grahams investing philosophy. Two of the screens, Graham Defensive Investor (Non-Utility) and Graham Enterprising Investor, were the top-performing value strategies in 2005, and both have respectable long-term records. This article briey outlines Grahams investing philosophy, and then describes the performance and characteristics of the two top-performing AAII screens that are based on Grahams value approach.
itself over time to be a highly successful investment approach. And while success has many fathers, Benjamin Graham is certainly one of them. In this case, father really does know best.
Grahams Philosophy
In 1947, Graham published The Intelligent Investor, a book that outlined in detail his investment philosophy, and which he continued to update periodically. The book is now considered an investment classic. In the book, Graham describes how his approach would be applied by two different types of investorsthose that are
For the Defensive Investor, Graham recommends purchasing shares of important companies that have histories of long-term protability and strong nancial positions. To Graham, important companies are those of substantial size, based on annual sales, with a leading position in a leading industry. Additionally, Graham seeks companies with: Strong nancial positions, as indicated by the current ratio (current assets divided by current liabilities) and the ratio of long-term debt to working capital (current assets minus current liabilities); 10 years of positive earnings; 20 years of uninterrupted dividends; A 10-year annual earnings growth rate of at least 3%; A reasonable price-earnings ratio (Graham modies this ratio by averaging earnings over several years to overcome business cycles and the impact of special charges); A moderately low ratio of price to assets (calculated by multiplying the price-earnings ratio by the price-to-book value ratio).
Enterprising Investors
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450% 400% 350% 300% 250% 200% 150% 100% 50% 0% -50% 2006
Monthly Std Dev Cum'l (%) 345.0 5.9 415.8 8.0 72.8 4.6 134.3 5.5 109.7 5.8 223.7 6.6
Current earnings higher than earnings ve years ago; A low price-to-book ratio. Graham also suggests a minimum of 10 holdings, but prefers a larger group of 30 securities.
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Return (%) 1998 1999 2000 2001 2002 2003 2004 2005 YTD Graham Defensive Investor (Non-Utility)* 9.6 3.6 12.0 61.5 3.1 32.7 11.7 26.2 12.4 Graham Enterprising Investor* (7.3) (5.0) 24.2 55.3 43.5 25.9 18.9 21.3 16.5 S&P 500 26.7 19.5 (10.1) (13.0) (23.4) 26.4 9.0 3.0 2.5 5.8 S&P MidCap 400 17.7 13.3 16.2 (1.6) (15.4) 34.0 15.2 11.3 5.7 (15.3) 37.8 21.4 6.7 8.3 S&P SmallCap 600 (2.1) 11.5 11.0 All Exchange-Listed Stocks 5.9 35.1 (14.2) 21.2 (13.3) 81.1 22.8 4.5 7.9 *Price performance of hypothetical portfolio rescreened and rebalanced monthly using month-end closing prices and no transaction costs. Data as of January 31, 2006.
promising investments among rms outside of the important companies. He suggests looking among: large companies unpopular, indicated by a low price-earnings ratio (P/E); smaller companies in a top industry; or, top rms in an unimportant industry. However, he advises against small, undervalued companies, believing the company may not be able to sustain itself through an unstable or adverse market. Additional criteria for Enterprising Investors are: A price-earnings ratio in the bottom 10% of all stocks; Financial strength based on the current ratio and ratio of longterm debt to working capital; Positive earnings for the past ve years; Dividend paying;
*Within AAIIs Stock Investor Pro, the Defensive Non-Utility Graham screen is labeled Graham (Defensive-Industrial), the Enterprising screen is labeled Graham (Enterprising), and the Defensive Utility screen is labeled Graham (Defensive-Utility).
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AAII Journal
Performance
Figure 1 shows the performance of the Graham Defensive (Non-Utility) screen and the Graham Enterprising Investor screen since 1998. Both screens got off to a slow start, lagging the S&P 500 until 2000 with the Enterprising screen posting negative returns for 1998 and 1999. However, the Graham approaches are value-oriented, so the early market-lagging performance is not a surprise. The late 1990s marked the tail-end of a bull market, an environment in which the focus was on growth (particularly Internet stocks during this tech bubble), and value approaches in general tended to lag the market. The market environment changed dramatically when the technology sector bubble burst, causing value to come into favor once again. In 2001, both screens saw their highest yearly return61.5% for the Defensive screen and 55.3% for the Enterprising screenin contrast to the S&P 500, which lost 13.0%. Cumulatively, each screen has outperformed the S&Ps small-, mid-, and large-cap indexes since 1998. The Defensive Investor screen has gained 345.0% from January 1998 through January 31, 2006, while the Enterprising Investor screen logged a higher return of 415.8% over the same period.
passed the Defensive Investor (NonUtility) screen, while only one passed the Enterprising Investor screen.
Portfolio Turnover
On average, the Defensive (NonUtility) screen has 17 stocks passing each month, with an average monthly turnover rate of 21.2%. The Enterprising screen has, on average, only ve stocks passing each month, with a 35.4%
Company (Exch: Ticker) Graham Defensive Investor (Non-Utility) Ashland Inc. (N: ASH) POSCO (ADR) (N: PKX) Schnitzer Steel (M: SCHN) Liz Claiborne, Inc. (N: LIZ) Briggs & Stratton (N: BGG) Steel Tech (M: STTX) Graham Enterprising Investor POSCO (ADR) (N: PKX)
Div Yield (%) 1.7 1.8 0.2 0.7 2.6 1.1 1.8
Description paving & spec chems mfgs steel auto parts & steel brand apparel gas engines steel processor
Exchange Key: M= NASDAQ National or NASDAQ Small Cap Market, N= New York Stock Exchange. Source AAIIs Stock Investor Pro/Reuters Research, Inc. Data as of 2/10/2006. Pro
April 2006
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Because Graham focuses on nding stocks selling at a signicant discount, the price-earnings ratio is an important characteristic for both Defensive and Enterprising Investors. Grahams Defensive Investor screen uses a modied version of the price-earnings ratio, which averages earnings over several years to account for special charges and to overcome the impact of cyclical business. Grahams price-earnings ratio requirement for the Defensive Investor seeks to produce a stock portfolio that is reasonably priced compared to the current yield of AA bonds; in todays interest rate environment, the Defensive Investor screen requires a modied price-earnings ratio of 20 or less [for more on how Graham determines the price-earnings ratio for the Defensive Investor, see the box on page 23]. Graham set a more restrictive priceearnings ratio level for Enterprising Investors, who should look for stocks with a price-earnings ratio in the lowest 10% of all stocks. As of February 10, 2006, that means a price-earnings ratio of 9.5 or lower. Due to the value orientation of Grahams screens, it is not surprising to see in Table 1 that the median price-earnings ratio of the passing companies (9.1 for Defensive and 3.6 for Enterprising) is much lower than the typical exchangetraded stock (20.4). Table 2 shows that Steel Technologies, Inc. is the richest passing company, with a price-earnings ratio of 14.0.
Price-to-Book Ratios
Graham recommends that Defensive Investors multiply the price-earnings ratio by the price-to-book ratio and seek stocks where that value does not exceed 30 (an acceptable modied price-earnings ratio of 20 times a 1.5 price-to-book ratio). Graham recommends that Enterprising Investors should look for stocks with a price per share that is less than or equal to 1.2 times its tangible book assets (price-to-book ratio), a more restrictive criteria. Not surprisingly, given these restrictions, Table 1 indicates that the median price-to-book ratios for both the Defensive screen (1.43) and Enterprising screen (0.95) are less than the typical exchange-traded stock (2.29).
Earnings Stability
Graham also looks for securities with low price-to-book ratios, generally below 1.5. However, he feels that a low price-earnings ratio can justify a slightly higher price-to-book ratio.
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Earnings stability is another important principle for Graham. Both screens require positive historical earnings and strong earnings growth rates. The Graham Defensive (Non-Utility) screen requires seven years of positive earnings and a seven-year annualized earnings per share growth rate of 3% or higher. [Although Graham suggests investors examine a 10-year earnings history, the AAII screen is constrained by the Stock Investor Pro database earnings history, which is limited to seven years.] The Graham Enterprising screen is less restrictive, requiring only positive earnings over the last ve years; it also requires that current scal-year earnings be higher than earnings ve years ago. Both screens have a higher historical earnings growth rate22.7% for Defensive and 20.8% for Enterprisingthan the average exchange-traded stock, with a 10.2% median growth rate. Among the passing companies listed in Table 2, Briggs & Stratton Corporation has the lowest seven-year annualized earnings growth rate of 9.2%, while Schnitzer Steel Industries has an impressive 51.0% annualized growth rate. Grahams focus on strong earnings growth and low price-earnings ratios is reected in the lower median PEG ratios (price-earnings ratio divided by
In addition to earnings growth, Graham is a rm believer in dividends. Both screens look for companies that pay dividends. The Graham Defensive (NonUtility) screen requires that a company has paid a dividend over the trailing 12 months and for each of the last seven years. [Although Graham suggests investors examine a 20-year dividend history, the AAII screen is constrained by the Stock Investor Pro database dividend history, which is limited to seven years.] As with other criteria for the Enterprising Investor, the dividend criteria for this screen is more relaxed, only calling for a dividend payment over the trailing 12-month period. Both screens also require that a company intends to pay a dividend over the next four scal quarters. Dividend yields for the current list of passing companies range between 0.2%, for Schnitzer Steel, and 2.6%, for Briggs & Stratton Corporation.
Strong Financial Position
Graham believes that a company with a strong nancial position can continue to prosperor at least not failduring a downturn in the market. A rms current ratio (current assets divided by current liabilities) shows the liquidity of a companys assets; the higher the ratio, the stronger the nancial position of the rm. The Graham Defensive Investor screen looks for stocks with a current ratio of at least 2.0, while the Enterprising Investors screen considers stocks with a slightly lower current ratio of 1.5. Table 2 shows that Steel Technologies Inc. currently has the highest current ratio of 3.4. In addition to liquidity, Graham looks to long-term debt and its relationship to working capital (current assets minus current liabilities) as another measure of nancial stability. For both screens, Graham believes long-term debt should not exceed net
current assets or working capital. The AAII screens have quantied this by using a long-term debt to working capital ratio, which, Graham species, should always be positive and less than or equal to 100%. Table 2 indicates that Ashland Inc. has by far the lowest ratio of long-term debt to working capital, at 3.6%.
Market Capitalization
Most of the stocks currently passing these two screens have median market capitalizations much larger than the typical exchange-listed stock ($457.6 million). This is to be expected, since Graham favors larger companies, and the Defensive Investor (Non-Utility) screen requires annual sales of at least $400 million. (The annual sales requirement has been raised from Grahams original recommendation of $100 million due to ination.) The median market cap of a
stock currently passing the Defensive Investor (Non-Utility) screen is $2.7 billion while the one stock passing the Enterprising screen has a market capitalization of $17.6 billion. Three of the six companies passing the Defensive screen, including the one company also passing the Enterprising screen, are in the steel business. Most likely this is due to the cyclical nature of the steel industry and a slowing demand for cars and new homes.
Relative Strength
strength of 0%).
Conclusion
Grahams investing philosophy focuses on nding larger, well-known companies with strong historical growth rates that are selling at a discount. Despite a slow start in 1998 and 1999, this approach, as embodied in AAIIs Graham Defensive Investor (Non-Utility) and Enterprising Investor screens, has proved to be a winning strategy over the last eight years. The passing companies of each screen do not represent a list of recommended stocks. As with all types of investing, it is important to perform due diligence to verify the stocks nancial strength and earning potential. It is also essential to decide if the stocks match your investing style and risk tolerance before committing your investment dollars.
Over the past 52 weeks, the stocks currently passing the Defensive Investor (Non-Utility) screen have underperformed the S&P 500 by 18%, while the single stock passing the Enterprising Investor screen has outperformed the market by 12%. The typical exchange-traded stock has matched the performance of the S&P over the same time period (relative
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