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Winning Approach for Enterprising & Defensive Investors
By Cara Scatizzi
Graham’s approach focuses on determining the “intrinsic” value of a stock, which takes into consideration the ﬁrm’s earnings, tangible assets, dividends, ﬁnancial 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 Graham’s 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 brieﬂy outlines Graham’s investing philosophy, and then describes the performance and characteristics of the two top-performing AAII screens that are based on Graham’s 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.
Value investing has proven
“defensive” and those that are “enterprising.” The defensive, or passive, investor is one who does not have or is not willing to spend a great deal of time analyzing or tracking individual stocks. In contrast, the Enterprising Investor has greater market experience, as well as additional time to devote to portfolio management.
The Defensive Investor
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 investors—those that are
For the Defensive Investor, Graham recommends purchasing shares of “important” companies that have histories of long-term proﬁtability and strong ﬁnancial 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 ﬁnancial 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 modiﬁes 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).
Graham encourages Enterprising Investors to search for
AAII Stock Screens
AAII Stock Screens
Figure 1. Graham Screens
S&P 500 Enterprising Defensive (Non-Utility)
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 ﬁve years ago; • A low price-to-book ratio. Graham also suggests a minimum of 10 holdings, but prefers a larger group of 30 securities.
AAII’s Graham Screens
AAII developed two separate screens that attempt to closely replicate Graham’s principles, one for the Defensive Investor and one for the Enterprising Investor. The screens were developed using Stock Investor Pro, AAII’s fundamental stock screening and research database. These two screens were the top-performing value screens for 2005. A complete list of the screening criteria for the two strategies can be found at the end of this article. Stock Investor Pro includes Graham’s Defensive (Non-Utility)* and Enterprising Investor screens (along with a Defensive Investor (Utility) screen not discussed in this article).
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 ﬁrms 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 ﬁrms 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 ﬁve years; • Dividend paying;
Table 1. Portfolio Characteristics for Graham Screens
Graham Defensive Investor Portfolio Characteristics (Median) (Non-Utility) Price-earnings ratio (X) 9.1 Price-to-book-value ratio (X) 1.43 PE to EPS estimated growth (X) 0.95 EPS 5-yr. historical growth rate (%) 22.7 EPS 3-5 yr. estimated growth rate (%) 11.6 Dividend yield (%) 1.4 Current ratio (X) 2.5 LT debt to working capital (%) 38.9 Market cap. ($ million) 2,708.5 Relative strength vs. S&P (%) –18 Monthly Observations Average no. of passing stocks Highest no. of passing stocks Lowest no. of passing stocks Monthly turnover (%) 17 35 1 21.2 All Graham ExchangeEnterprising Listed Investor Stocks 3.6 20.4 0.95 2.29 0.40 1.40 20.8 10.2 11.2 14.5 1.8 0.0 2.1 2.1 26.5 17.5 17,621.7 457.6 12 0 5 15 0 35.4
*Within AAII’s 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).
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 return—61.5% for the Defensive screen and 55.3% for the Enterprising screen—in contrast to the S&P 500, which lost 13.0%. Cumulatively, each screen has outperformed the S&P’s 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.
Determining the P/E Cut-Off for Graham’s Defensive Investor
In “The Intelligent Investor,” Graham’s goal for the Defensive Investor was to establish a portfolio whose earnings yield [earnings divided by price (E/P), or the inverse of the price-earnings ratio] was at least comparable to that of 10-year AA bonds. Therefore, he required the price-earnings ratio to be no higher than the inverse of investment-grade bond yields. Additionally, Graham modiﬁes the price-earnings ratio by using the average earnings over the last three years to account for special charges and to overcome cyclical business impacts. At the time Graham wrote his book, investment-grade bonds were yielding 7.5%; the inverse of that yield (1 divided by 0.075) determined the overall portfolio price-earnings ratio objective of 13.3. But current long-term high-grade corporate bond yields differ from those prevailing when Graham set his price-earnings objective, and therefore the cut-off needs to be adjusted. When bond yields increase, Graham’s formula requires a lower price-earnings ratio. Conversely, lower bond yields mean that an investor could accept a higher price-earnings cut-off, which makes more stocks available for consideration. The current AA 10-year bond yield is 5.1%; the inverse of the current bond yield (1 divided by 0.051) is 20.
Proﬁle of Passing Companies
Table 1 lists the characteristics of the stocks passing the Graham Defensive Investor (Non-Utility) screen and the Graham Enterprising Investor screen as of February 10, 2006. Table 2 lists the passing stocks, ranked in ascending order by price-earnings ratio. The number of passing stocks for each screen is small—six companies
passed the Defensive Investor (NonUtility) screen, while only one passed the Enterprising Investor screen.
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 ﬁve stocks passing each month, with a 35.4%
Table 2. Companies Passing the Graham Screens
PE Using EPS PE Avg EPS PB Grth Ratio 3 Yrs Ratio 7 Yr (X) (X) (X) (%) 2.4 5.7 1.3 39.5 3.6 8.0 1.0 30.5 6.6 9.5 1.5 51.0 11.5 13.6 1.8 11.8 12.9 15.2 2.0 9.2 14.0 11.9 1.3 19.3 3.6 8.0 1.0 30.5 LT Debt/ 52Current Working Wk Ratio Capital Mkt Rel Q1 Q1 Cap Strgth (X) (%) ($Mil) (%) 2.7 3.6 4,598.0 –3.0 2.1 26.5 17,621.7 12.0 2.6 37.1 945.4 –18.0 2.3 46.9 3,643.1 –24.0 2.4 59.1 1,773.8 –19.0 3.4 40.6 345.3 –18.0 2.1 26.5 17,621.7
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
12.0 mfgs steel
Exchange Key: M= NASDAQ National or NASDAQ Small Cap Market, N= New York Stock Exchange. Source AAII’s Stock Investor Pro/Reuters Research, Inc. Data as of 2/10/2006. Pro
AAII Stock Screens
average monthly turnover rate. It is not a surprise that both Graham screens have low turnover rates compared to all of the strategies AAII follows, since value strategies in general tend to have lower turnover.
Because Graham focuses on ﬁnding stocks selling at a signiﬁcant discount, the price-earnings ratio is an important characteristic for both Defensive and Enterprising Investors. Graham’s Defensive Investor screen uses a modiﬁed 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. Graham’s 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 today’s interest rate environment, the Defensive Investor screen requires a modiﬁed 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 Graham’s 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.
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 modiﬁed 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).
the estimated earnings per share growth rate for ﬁve years).
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.
24 AAII Journal
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 ﬁve years; it also requires that current ﬁscal-year earnings be higher than earnings ﬁve years ago. Both screens have a higher historical earnings growth rate—22.7% for Defensive and 20.8% for Enterprising—than 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. Graham’s focus on strong earnings growth and low price-earnings ratios is reﬂected in the lower median PEG ratios (price-earnings ratio divided by
In addition to earnings growth, Graham is a ﬁrm 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 ﬁscal 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 ﬁnancial position can continue to prosper—or at least not fail—during a downturn in the market. A ﬁrm’s current ratio (current assets divided by current liabilities) shows the liquidity of a company’s assets; the higher the ratio, the stronger the ﬁnancial position of the ﬁrm. 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 ﬁnancial stability. For both screens, Graham believes long-term debt should not exceed net
current assets or working capital. The AAII screens have quantiﬁed this by using a long-term debt to working capital ratio, which, Graham speciﬁes, 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%.
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 Graham’s original recommendation of $100 million due to inﬂation.) 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.
strength of 0%).
Graham’s investing philosophy focuses on ﬁnding 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 AAII’s 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 stock’s ﬁnancial 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
What It Takes: Graham Criteria
Enterprising: Defensive (Non-Utility): • The price-earnings ratio is among the lowest 10% • Those companies that are part of the utilities secof the database (Percent Rank less than or equal tor are excluded to 10) • Sales over the last 12 months are greater than or • The current ratio for the last ﬁscal quarter (Q1) is equal to $400 million greater than or equal to 1.5 • The current ratio for the last ﬁscal quarter (Q1) • The long-term debt to working capital ratio for is greater than or equal to 2.0 the last ﬁscal quarter (Q1) is greater than 0% and • The long-term debt to working capital ratio for less than 110% the last ﬁscal quarter (Q1) is greater than 0% and • Earnings per share for each of the last ﬁve ﬁscal less than 100% years and for the last 12 months have been posi• Earnings per share for each of the last seven ﬁscal tive years and for the last 12 months are positive • The company intends to pay a dividend over • The seven-year growth rate in earnings per share the next year (indicated dividend is greater than is greater than 3% zero) • The company intends to pay a dividend over the • The company has paid a dividend over the last 12 next year (indicated dividend greater than zero) months • The company has paid a dividend for each of • Earnings per share for the last 12 months are the last seven ﬁscal years and over the last 12 greater than the earnings per share from ﬁve years months ago (Y5) • A modiﬁed price-earnings ratio of 20 or less (see • Earnings per share for the last ﬁscal year (Y1) are box on page 23) greater than the earnings per share from ﬁve years • The price-earnings ratio multiplied by the price-toago (Y5) book ratio is less than or equal to 30 (price-earn• The price-to-book ratio is less than or equal to ings ratio maximum of 20 times 1.5, which is the 1.2 maximum price-to-book ratio)
Cara Scatizzi is associate ﬁnancial analyst at AAII.
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