Benjamin Graham

Chapter 14 – Stock Selection for the Defensive Investor

Summary and Discussion – Chapter 14 – Stock Selection for the Defensive Investor
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created May 21st, 2014
Last updated June 3rd, 2014
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • Value investing is concerned principally with quantitative analysis of past and present information, with the goal of minimizing investment errors.
  • Forecasting (or “projecting”) future events is not a part of Graham’s methodology.
  • Risk can be minimized by restricting one’s investments to securities which meet rigorous standards of quality and price.

In chapter 5, Graham lays out four general rules to guide defensive investors in the selection of common stocks. These were: [1]

  1. Diversification. Diversify your holdings between approximately 10 to 30 companies.
  2. Market capitalization and financial strength. Only select companies that are “large, prominent, and conservatively financed.” [2] We’ll elaborate on this point throughout this article.
  3. Uninterrupted dividends. Only select companies that have a long history of uninterrupted dividend payments. Graham recommends a period of at least 20 years’ continuous dividends.
  4. A reasonable price. Ensure that you do not pay too high a price for the company’s earnings. Specifically, do not pay more than 25 times the company’s average earnings over the past 7 years, “and not more than 20 times those of the last twelve-month period.” [3]

At the start of chapter 14, Graham expands on these general principles with a list 7 guidelines:

  • Adequate Size of the Enterprise. Small companies should be excluded owing to their heightened volatility relative to larger companies. [4] Graham posits minimum annual sales of $100 million “for an industrial company” and “not less than $50 million of total assets for a public utility.” [5]
      1. Inflation-adjusted figures (1971 to 2014): [6]
        1. Annual sales of roughly $600 million for an industrial company.
        2. Total assets of roughly $300 million for a public utility.
  • A Sufficiently Strong Financial Condition.
      1. For industrial companies:
        1. Current assets must be at least twice the current liabilities.
        2. Long-term liabilities should not exceed working capital. [7]
      2. For public utilities:
        1. Total debt should be less than 200% of “stock equity (at book value).” [8]

– Earnings Stability. The company must have been profitable in each of the past 10 years. [9]

– Dividend Record. The company must have paid uninterrupted dividends for each of the past 20 years (or more). [10]

– Earnings Growth. The company must have achieved at least a ~33% (one-third, to be exact) increase in earnings per share over the past ten years. In other words, it must have increased its EPS at an annual rate of roughly 3% (2.75%) over each of the past ten years. Graham measures this by comparing three-year averages at the beginning and at the end of the decade, but this is simply for ease of arithmetic. [11]

– Moderate Price to Earnings Ratio. “Current price should not be more than 15 times the average earnings of the past three years.” [12]

– Moderate Ratio of Price to Assets. “Current price should not be more than [1.5] times the book value last reported. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (This figure corresponds to 15 times earnings and [1.5] times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)” [13]

After ending his list, Graham offers an additional recommendation. For our purposes, we can include it as an 8th item in his list of guidelines:

  • Moderate Overall Ratio of Earnings to Price. This last recommendation pertains to the portfolio as a whole, not to any individual security. Graham posits that “the stock portfolio… should have an overall earnings/price ratio—the reverse of the P/E ratio—at least as high as the current high-grade bond rate.” [14] In 2014, this would correspond to an overall P/E ratio of 24 times, based on an average AAA corporate bond yield of 4.23%. [15] Note that this figure is intended as a maximum PE ratio. It is prudent to maintain a margin of safety by ensuring that the average company within the portfolio should have a PE at least 20% below the maximum figure. This would correspond to a PE of roughly 19 times earnings (based, once again, on 2014 AAA corporate bond yields).

Over the next several pages, Graham goes on to apply these criteria to the Dow Jones Industrial Average (c. 1971), checking how many of its listed companies conform to the above guidelines. Instead of revisiting Graham’s data, we can build our own tables using data from May 2014. In the interest of time, I will use fewer companies than in Graham’s original tables.

Table 1 – Basic Data on 9 Stocks in the Dow Jones Industrial Average at May 24th, 2014. [16]

Price, May 23rd 2014 Revenues: 2013 (millions) [17] EPS: 2013 Average EPS: 2011 to 2013. Average EPS: 2001 to 2003. Uninterrupted dividends paid since [18] Net Asset Value
(millions) [19]
Current Dividend (annual) [20]
American Express (AXP) $88.78 $32,974 $4.91 $4.18 $1.76 1977
(37 years)
$19,496 $0.92
Boeing (BA) $132.41 $86,623 $5.95 $5.46 $1.64 1962
(52 years)
$14,875 $2.92
Caterpillar (CAT) $104.03 $55,656 $5.98 $7.47 $2.58 1982
(33 years)
$20,811 $2.40
Cisco (CSCO) $24.52 $48,607 $1.87 $1.60 $0.20 2011
(3 years)
$59,120 $0.76
Chevron (CVX) $123.37 $228,848 $10.87 $12.58 $3.71 1998
(31 years)
$149,113 $4.28
DuPont (DD) [21] $68.10 $36,144 $3.49 $3.48 $1.34 1962
(52 years)
$16,229 $1.80
Disney (DIS) $83.32 $45,041 $3.49 [22] $3.04 $0.40 1981
(33 years)
$45,429 $0.86
General Electric (GE) $26.51 $146,045 $1.47 $1.36 $1.42 1962
(52 years)
$130,566 $0.88
Goldman Sachs (GS) $160.16 $34,206 [23] $17.11 $12.07 $4.72 2000
(14 years)
$78,467 $2.20

 Table 2 – Significant Ratios of 9 DJIA Stocks at May 24th, 2014 [24]

P/E: May 2014 [25] P/E: 2011 to 2013 Current Dividend Yield [26] Earnings Growth 2011-2013 vs. 2001-2003 Current Assets / Current Liabilities [27] Net Current Assets / Debt [28] Price / Net Asset Value [29] Price / Book Value [30]
American Express (AXP) 18.08 21.24 1.04% 138% 2.10 [31] 18.48% 439% 4.85
Boeing (BA) 22.25 24.25 2.21% 233% 1.26 51.90% 1447% 6.79
Caterpillar (CAT) 17.40 13.93 2.33% 190% 1.40 30.06% 647% 3.14
Cisco (CSCO) 13.11 15.33 3.12% 700% 2.95 275.81% 389% 2.26
Chevron (CVX) 11.35 9.81 3.46% 239% 1.52 24.51% 162% 1.55
DuPont (DD) 19.51 19.57 2.67% 160% 1.82 50.43% 976% 3.94
Disney (DIS) 23.87 27.41 1.04% 660% 1.21 11.25% 1088% 3.24
General Electric (GE) 18.03 19.49 3.32% (- 4%) [32] 1.37 [33] 3.06% 593% 2.04
Goldman Sachs (GS) 9.36 13.27 1.38% 156% 1.37 [34] 10.21% 92% 0.99

 Application of Our Criteria to the DJIA at the end of 2013

Based on the data tabled above, how many of the companies surveyed would have satisfied Graham’s criteria? Let’s remind ourselves of what those criteria are and see how many made the cut. If you prefer, you can skip to the end of this list for a visual representation of how each company fared.

    1. Adequate Size of the Enterprise.
      1. Annual sales of roughly $600 million (figures adjusted for inflation).
        1. All companies met this criterion.
    1. Sufficiently Strong Financial Condition.
      1. Current assets at least equal to twice the current liabilities.
        1. Companies which met this criterion:
          1. American Express
          2. Cisco
      2. Long-term liabilities should not exceed working capital.
        1. Companies which met this criterion:
          1. Cisco
    1. Earnings Stability.
      1. Positive EPS for each of the past 10 years. [35]
        1. All companies met this criterion.
    1. Dividend Record.
      1. Uninterrupted dividends for at least the past 20 years.
        1. Companies which met this criterion:
          1. American Express
          2. Boeing
          3. Caterpillar
          4. Chevron
          5. DuPont
          6. Disney
          7. General Electric
        2. Companies which did not meet this criterion:
          1. Cisco
          2. Goldman Sachs
    1. Earnings Growth.
      1. At least a ⅓ increase in earnings per share over the past ten years.
        1. Companies which met this criterion:
          1. All, except General Electric
        2. Companies which did not meet this criterion:
          1. General Electric
    1. Moderate Price to Earnings Ratio.
      1. Maximum P/E of 15, based on average earnings of the past three years.
        1. Companies which met this criterion:
          1. Caterpillar
          2. Chevron
          3. Goldman Sachs
    1. Moderate Ratio of Price to Assets.
      1. “Current price should not be more than [1.5] times the book value last reported.” [36]
        1. Companies which met this criterion:
          1. Goldman Sachs
        2. Companies which did not meet this criterion:
          1. All others.
      2. Rule of thumb: The product of the P/E ratio and the Price/Book ratio should not exceed 22.5. [37]
        1. Companies which met this criterion:
          1. Chevron (17.60)
          2. Goldman Sachs (9.27)
        2. Companies which did not meet this criterion:
          1. American Express (87.69)
          2. Boeing (151.20)
          3. Caterpillar (54.64)
          4. Cisco (29.63)
          5. DuPont (76.87)
          6. Disney (77.34)
          7. General Electric (36.78)
    1. Moderate Overall Ratio of Earnings to Price.
      1. Maximum overall P/E ratio of 19, based on a 4.23% yield on AAA corporate bonds for the portfolio as a whole and an additional 20% margin of safety. Do our nine DJIA selections pass this criterion?
        1. Portfolio-wide P/E: 1/9(18.08+22.25+17.4+13.11+11.35+19.51+23.87+18.03+9.36) = ~17.
        2. –> Yes.

Green = fully satisfies criterion; Yellow = partially satisfies criterion; White = does not satisfy criterion.

Visual Valuation Table

Graham ends this chapter by distinguishing between two broad approaches to investing:

“The first, or predictive, approach could also be called the qualitative approach, since it emphasizes prospects, management, and other nonmeasurable, albeit highly important, factors that go under the heading of quality. The second, or protective, approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends, and so forth.” [38]

Benjamin Graham’s school of value investing is firmly rooted in the quantitative, or “protective”, approach. It is my hope that this article provides some useful examples of the ways in which this approach can be employed.

 

At the time of publication, Jason Fernando had no positions in any of the securities mentioned in this article. He does not intend to trade any of the securities mentioned in this article within 48 hours of publication.

 

Footnotes
[1] 114-115.
[2] 114.
[3] 115.
[4] Another advantage of excluding small companies is that they generally possess less liquidity than their larger counterparts.
[5] 348.
[6] These figures were produced using the US Department of Labour Statistics’ CPI Inflation Calculator: http://www.bls.gov/data/inflation_calculator.htm.
[7] Working capital consists of the current assets minus the current liabilities. It’s the money which the company has to work with after it has paid its short-term bills.
[8] See page348. This guideline is somewhat unclear as it is not obvious what exactly Graham means by “stock equity (at book value).” Depending on how this phrase is interpreted, it can refer either to a) the shareholders’ equity, meaning the company’s total assets minus its total liabilities; or b) its “Net Tangible Assets”, meaning the shareholders’ equity minus all intangible items such as patents, goodwill, etc. Joshua Kinnon wrote a good article explaining this distinction: http://beginnersinvest.about.com/od/analyzingabalancesheet/a/book-value.htm.
[9] 348.
[10] 348.
[11] 348.
[12] 349.
[13] 349.
[14] 350.
[15] Bond yield data courtesy of Moody’s, via WolframAlpha: http://www.wolframalpha.com/input/?i=AAA+Corporate+Bond+Index.
[16] This updated table follows in the spirit of Table 14-1, featured by Graham on page 351. All data from companies’ annual reports unless otherwise noted.
[17] This column was not included in Graham’s original table. Data from Morningstar.com.
[18] Data from www.dividata.com.
[19] Unfortunately, I am not entirely sure of how Graham defined “Net Asset Value” in his table. My original intention was to clarify this matter by digging into his companies’ 1971 annual reports and working backwards to arrive at his calculation. However, I soon realized that the annual reports which are available online rarely extend further back than the early 1990s. The one source which I found which seemed to contain annual reports from the 1970s was ProQuest’s Historical Annual Reports (http://www.proquest.com/products-services/pq_hist_annual_repts.html), but I do not have the necessary login credentials to access this archive. As a consequence of all this, I have decided to move forward on the assumption that Net Asset Value denotes Total Assets minus Total Liabilities (in millions USD).
[20] Data from www.dividata.com.
[21] DuPont’s full name is E. I. du Pont de Nemours and Company.
[22] In case you were wondering, I did not accidentally re-enter the EPS figure for DuPont; these two firms just happen to have had the same per-share earnings.
[23] This figure is net of interest expenses; “total interest and dividend income” was equal to $40,874 million.
[24] This updated table follows in the spirit of Table 14-2, featured by Graham on page 352. All data from companies’ annual reports unless otherwise noted.
[25] Note that Graham measures P/E as price divided by the average EPS of the past three years. See page 349.
[26] Data from www.dividata.com.
[27] Figures taken from 2013 year-end results.
[28] Net Current Assets (or “working capital”) is equal to Current Assets – Current Liabilities. The resulting figure is then divided by long-term debt.
[29] Determining price as a percentage of Net Asset Value requires three stages. To illustrate, consider the calculation for Chevron.  First, determine the Net Asset Value by subtracting Intangible Assets and Total Liabilities from Total Assets (Chevron example: $253,753,000,000 – $4,639,000,000 – $103,326,000,000 = $145,788,000,000). Next, determine the Net Asset Value Per Share (NAVPS) by dividing NAV by the number of Shares Outstanding (Ex: $145,788,000,000 / 1,909,130,328 = $76.36 per share). Lastly, divide the current share price by the NAVPS to arrive at the desired Price/NAV ratio (Ex: $123.37 / $76.36 = 162%).
[30] Graham originally included this ratio as part of a separate table (Table 14-4 on page 357). I’ve included it here for the sake of concision. All data from ADVFN.com.
[31] This particular figure should not be taken at face value; given that American Express does not include a specific line item for current assets or current liabilities on their balance sheet, this figure was calculated manually. I recommend that you consult the company’s 2013 annual report to come up with an estimate of CA/CL with which you are comfortable.
[32] I will follow Graham’s convention of emphasizing negative figures by placing them in brackets. This should not be interpreted as a double-negative!
[33] Same as footnote 31.
[34] Same as footnotes 31. This figure should be taken with a particularly large grain of salt.
[35] Based on diluted normalized EPS. For more information, see: http://www.investopedia.com/terms/d/diluted-normalized-earnings-per-share.asp.
[36] 349.
[37] See 349 for details.
[38] 365.

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