Benjamin Graham

Chapter 15 – Stock Selection for the Enterprising Investor

Summary and Discussion – Chapter 15 – Stock Selection for the Enterprising Investor
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created June 4th, 2014
Last updated July 15th, 2014

Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

In previous chapters, we have discussed the various guidelines set out by Graham to aid investors in the selection of a diversified and defensive portfolio of securities. In this chapter, Graham turns his focus to those “enterprising” investors who have the time, inclination and temperament to research individual securities in the hopes of generating superior returns on investment than the market as a whole.

To this end, however, he begins with a word of caution: Most actively managed investment funds actually underperform the market once their managers’ fees and other costs are accounted for. This illustrates the point that selecting above-average companies for investment is far more difficult than one might assume. For the vast majority of investors, a defensive approach to investing is probably advisable. [1]

With this caution aside, Graham introduces the reader to the world of the enterprising investor by drawing examples from his own career.

The Graham-Newman Partnership: Summary of Methods

During the thirty years in which Graham operated the Graham-Newman Corporation, he and his business partner Jerome Newman made use of the following methods of investment: [2]

  1. Arbitrages: [3] “The purchase of a security and the simultaneous sale of one or more other securities into which it was to be exchanged under a plan of reorganization, merger, or the like.” These kinds of situations are also referred to as “special situations” or “workouts”. More on these later.
  2. Liquidations: [4] “Purchase of shares which were to receive one or more cash payments in liquidation of the company’s assets.”

Note: Prior to engaging in either arbitrage or liquidation investments, Graham and Newman insisted that the investment must, by their best estimation, be both a) Likely to provide an annualized return on investment of 20% or more, and b) Have at least an 80% probability of materializing as expected. [5]

  1. Related Hedges: [6] Graham defines “Related Hedges” as “The purchase of convertible bonds or convertible preferred shares, and the simultaneous sale of the common stock into which they were exchangeable.” This method may seem initially unclear. To the best of my judgment, it would proceed as follows:
    1. The investor establishes the related hedge by simultaneously executing the following transactions:
      1. Purchase of convertible bonds or preferred shares in Company X.
      2. Short sale of common shares in Company X, where the number of shares involved in transactions “i” and “ii” are equal (meaning, the investor could cover the short sale through the conversion of the bonds or preferred shares).
    2. The investor closes the related hedge, in a manner which depends on which of the following scenarios takes place:
      1. The “good” scenario: The price of Company X’s common shares declines significantly, in which case the investor purchases the shares on the market for the new low price, thereby covering the initial short sale and profiting accordingly. [7] Company X’s convertible bonds/preferred shares can then be held to maturity or sold, depending on the preference of the investor.
      2. The “bad” scenario: The price of Company X’s shares increases, contrary to the wishes of the investor. The investor then decides to cover the short, and does so by converting her bonds/preferred shares. The related hedge is then closed, with the net effect that the investor is likely to have incurred a modest loss due to the costs associated with the above transactions. Unlike a straightforward short sale, the investor’s exposure to losses is limited; her risk of loss is “hedged” through the purchase of the convertible bonds/preferred shares.
  1. Net-Current Asset (or “Bargain”) Issues: [8] This method consists of purchasing companies whose price is equivalent to less than the per-share value of two-thirds of the company’s net current asset value, where net current asset value is defined as its current assets minus its total liabilities. As an equation, this criteria can be expressed as follows:
    Price ≤ [0.67 (Current Assets – Total Liabilities)] / Shares Outstanding

Note: Adequate diversification is of central importance to the method of Net-Current-Asset-Value (or “NCAV”) investing. Benjamin Graham, for instance, “carried… at least 100 different issues” in the NCAV portion of his portfolio. [9] Such diversification is important in order to minimize the degree to which the failure of any given company would adversely affect the overall portfolio.

Graham also notes that two additional methods were employed, but were subsequently discontinued after having been “found not to have shown satisfactory overall results.” [10] These were:

  1. Investments in companies which did not meet the “Net-Current-Asset” criteria.
  2. “Unrelated hedging operations, in which the purchased security was not exchangeable for the common shares sold.” [11]

These four methods of investment may seem overly limiting to many investors. “Most active-minded practitioners,” Graham writes, “would prefer to venture into wider channels.” [12] Such investors may be interested in pursuing what Graham calls secondary companies.

What are secondary companies? “Secondary Companies” are a distinct category from “Discount”/net-current-asset-value issues. They are “companies that are making a good showing, have a satisfactory past record, but appear to hold no charm for the public.” [13] These are solid companies which, due to being out of vogue with the market, can be purchased at attractive prices. They are, however, not “bargains” in Graham’s strict sense of the word.

Where to begin? In setting out to find secondary companies, it is necessary to impose some criteria through which to pare down the long list of publicly traded corporations. To this end, Graham recommends beginning with a maximum price-earnings ratio of 9, based on the trailing 12-months’ earnings. Graham recommends the Standard & Poor’s Stock Guide as a resource through which to conveniently access this statistical information, although modern readers can follow along with Graham’s search through the use of free online databases such as those offered by Google Finance, Yahoo Finance, or CNBC. For our purposes, I will apply Graham’s criteria using Google Finance’s Stock Screener program, available at https://www.google.com/finance#stockscreener. For the sake of simplicity, I will also be limiting our search to American companies.

Before applying any criteria, our search is hopelessly broad. According to the Wall Street Journal, there were approximately 5,000 publicly traded corporations in the United States in 2013. [14] By applying a maximum P/E ratio of 9 we can begin to limit our search, limiting our results to 1,046 companies. [15] We can further reduce our search by introducing the following criteria (criteria which are not precisely covered by Google Finance’s screener are flagged with an asterix):

  1. Current Assets ≥ 150% of Current Liabilities. Current assets must be at least 150% of current liabilities, i.e. a company with $1 million of current liabilities must have at least $1.5 million in current assets. This limits our list to 237 eligible companies.
  2. *Total Debt ≤ 110% of Net Current Assets. Debt must not exceed 110% of net current assets, where “net current assets” refers to current assets minus current liabilities. For this criteria, the closest match available on Google Finance is Total Debt divided by Total Assets. Readers should note that this is a departure from the criteria recommended by Graham. Having applied this criteria, our list is reduced to 236 companies.
  3. *Positive earnings in each of the last five years. Here again, the Google Finance screener lacks an accurate analogy to Graham’s criteria. As an imperfect approximation, we can implement a minimum 5-year EPS growth rate of 10%, thereby limiting our search to 53 companies.
  4. Must pay a dividend. Graham does not specify any particular minimum quantity, instead insisting only that “Some current dividend” be paid. For our purposes, we may implement a minimum dividend yield of 0.1%. [16] This further limits our search to only 15 companies.
  5. Earnings growth. Graham’s insists that the company’s most recent annual earnings must be greater than those from 5 years ago. In our case, this criteria was already imposed in step 3.
  6. *Price. Graham’s last criteria screens for companies priced at “Less than 120% of net tangible assets.” [17] Google Finance does not offer this criteria. However, given that we have now whittled the market down to 15 companies, it is feasible to study each of the issues by hand. To this end, we can make our job easier by excluding American Depository Receipts (ADRs) and other non-US companies from our list of results. If we do so, we are left with only 6 companies.
Criteria #6: Manual Calculation Example. Let’s use CF Industries Holdings, Inc. (NYSE: CF) as an example of how to determine whether a company’s market price is less than 120% of its net tangible assets. There are many roads to Rome, but these steps will get the job done.
1. Find the Net Tangible Asset Value (NTAV). As a reminder, net tangible assets are those assets left over after intangibles and liabilities are removed. In the case of CF Industries,
Net Tangible Assets
2. Find the Net Tangible Assets per Share (NTAVPS). To do so, you’ll need to know the number of shares outstanding. This information can be found on the first pages of the company’s annual “10-K” filing with the SEC. It can also be found online, such as through the Summary page of the company’s Google Finance listing.
Net Tangible Assets per Share
3. Calculate the Market Price as a Percentage of Net Tangible Assets per Share. Needless to say, you’ll need the market price to do so!Price as a Percentage of NTAVPS

Who Made the Cut?

After applying these six criteria, our investment “hunting ground” has been dramatically reduced. Let’s see which companies have met our criteria. [18]

Company Business Overview Market price Dividend yield P/E Ratio Current ratio Debt
/ Assets
Price as a % of NTAVPS
CF Industries Holdings, Inc. (CF) Fertilizer manufacturing and distribution. $240.46 1.66% 7.72 3.18 29.01% 426.65%
Cash America International Inc. (CSH) Payday loans, cheque cashing, etc. $42.61 0.33% 8.88 5.80 35.55% 369.24%
Celanese Corporation (CE) Chemical products manufacturing. $64.27 1.56% 8.79 2.06 33.98% 124.05%
Ebix Inc. (EBIX) Insurance
-industry software developer.
$12.53 2.39% 8.43 1.54 10.26% 355.97%
Federal Signal Corporation (FSS) Equipment manufacturing for emergency services. $14.25 0.84% 5.33 2.00 33.31% 1,158.54%
Inteliquent Inc. (IQNT) Network infrastructure for internet, cable, and wireless service providers. $14.05 2.14% 7.37 5.11 0.00% 390.28%

As the right-hand column indicates, every one of these companies has failed to meet Graham’s final criteria that its price must be no greater than 120% of its net tangible asset value (although Celanese Corporation came very close). It appears that investors wishing to assemble a portfolio of “secondary companies” are out of luck at the present time (July 2014), assuming that they wish to limit their search to American firms. I encourage you to experiment with applying Graham’s criteria to different markets, tweaking the variables of Graham’s criteria as you see fit. The power of The Intelligent Investor is not that it provides a set of hard-and-fast rules to follow, but rather that it provides a logical framework through which to develop your own techniques.

Before closing the chapter, Graham discusses two additional techniques which played an important part in the Graham-Newman Corporation’s investment activities: Bargain Issues and Workouts.

Bargain Issues

What are Bargain Issues? In Graham’s lexicon, the term “bargain issue” refers to a company whose shares can be purchased for less than the company’s net current asset value per share (“NCAVPS”). As a reminder, NCAVPS is measured as:

(Current Assets – Total Liabilities) / Number of Shares Outstanding

Graham’s general commentary on this approach cuts to the heart of the matter:
“It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone—after deducting all prior claims, and counting as zero the fixed and other assets—the results should be quite satisfactory.” [19]

Workouts

“Workouts”, also known as “special situations”, are in essence opportunities to profit from market mispricing. In other words, they are a form of arbitrage. Graham provides three real-world examples of workout opportunities. For those unfamiliar with the general mechanics of arbitrage, these examples may seem fairly unclear. I will seek to clarify this section by providing tables which delineate the steps involved in order to profit from each situation. [20]

Situation 1: January 1971, Acquisition of Kayser-Roth by Borden’s. [21] “In January 1971 Borden Inc. announced a plan to acquire control of Kayser-Roth (“diversified apparel”) by giving 1⅓ shares of its own stock in exchange for one share of Kayser-Roth. On the following day, in active trading, Borden closed at 26 and Kayser-Roth at 28. If an “operator” had bought 300 shares of Kayser-Roth and sold 400 Borden at these prices and if the deal were later consummated on the announced terms, he would have had a profit of some 24% on the cost of his shares, less commissions and some other items. Assuming the deal had gone through in six months, his final profit might have been at about a 40% per annum rate.”

Recap of Situation 1

Overview
January 1971: Borden announces plan to acquire Kayser. Offer:- Give 1⅓ shares of Borden stock.
– Receive 1 share of Kayser stock.Next day (market close):
Borden: $26/share
Kayser: $28/shareHypothetical transaction
1) Buy 300 Kayser shares @ $28/share = $8,400 purchase cost.
Sell 400 Borden shares short @ $26/share = $10,400 gain.
Balance = $10,400 – $8,400 = $2,000 (ignores commissions, fees, interest, and margin-call risk).
2) Time passes
3) Deal is consummated.
Effects:- Before:
– You own 300 shares of Kayser with a market value of $8,400.
– You owe 400 shares of Borden.
– You have a balance of $2,000.- After:
For every 1 share of Kayser stock, you get 1⅓ shares of Borden stock. Therefore, 300 shares of Kayser becomes 300 * 1.33 = ~400 shares of Borden. You then cover your short with the 400 Borden shares and retain the $2,000 balance.
Net effect of transaction
– You own 0 shares.
– You owe $0.
– You made $2,000
What did you spend?
– $8,400 on the initial 300 Kayser shares.
– What did you net?2000 / 8400 =23.81%.
Review of steps involved in hypothetical transaction (ignores commissions, fees, interest, and margin-call risk):
1) Identify announcement of takeover and clarify its terms.
2) Buy shares in the company that will be acquired.
3) Short shares in the company that is making the acquisition.
4) Wait for the deal to be consummated.
5) Receive shares from acquisition.
6) Cover the short with the received shares.
7) Retain proceeds from step 3.

What ended up happening? “The directors of this company had already rejected (in January 1971) the Borden proposal when this chapter was written. If the operation had been “undone” immediately the overall loss, including commissions, would have been about 12% of the cost of the Kayser-Roth shares.” [22]

Further: “There is an interesting sidelight on our Kayser-Roth example. Late in 1971 the price fell below 20 while Borden was selling at 25, equivalent to 33 for Kayser-Roth under the terms of the exchange offer. It would appear that either the directors had made a great mistake in turning down that opportunity or the shares of Kayser-Roth were now badly undervalued in the market. Something for a security analyst to look into.” [23]

Situation 2: November 1970, Acquisition of Aurora Plastics Co. by National Biscuit Co. [24] “In November 1970 National Biscuit Co. offered to buy control of Aurora Plastics Co. at $11 in cash. The stock was selling at about 8½; it closed the month at 9 and continued to sell there at year-end. Here the gross profit indicated was originally about 25%, subject to the risks of non consummation and to the time element.”

Recap of Situation 2.

Acquisition offer:
– National Biscuit Co. offers $11/share, in cash.
– Aurora Plastics Co. was then trading for ~$8.50/share.
→ By year-end, Aurora Plastics Co. traded for $9/share, equivalent to 22% ROI if acquisition is successful.
Hypothetical transaction:
1) Identify acquisition offer.
2) Study terms of offer to assess possible ROI and estimated likelihood of consummation.
3) If risk/reward balance deemed appropriate, buy and hold pending consummation.
4) If acquisition is successful, achieve 22% ROI.

What ended up happening? “Because of the bad showing of this company in 1970 the takeover terms were renegotiated and the price reduced to $10.5/share. The shares were paid for at the end of May. The annual rate of return realized here was about 25%.” [25] Note that this took about 7 months.

Situation 3: 1970, Liquidation of Universal-Marion Co. [26] “Universal-Marion Co., which had ceased its business operations, asked its shareholders to ratify dissolution of the concern. The treasurer indicated that the common stock had a book value of about $28½ per share, a substantial part of which was in liquid form. The stock closed 1970 at 21½, indicating a possible gross profit here, if book value was realized in liquidation, of more than 30%.”

Recap of Situation 3.

The situation:
1) The directors of Universal-Marion Co. asked their shareholders to approve the liquidation of the business, based on the following premises:
a) The company had ceased its business operations, hence ongoing cashflow would be minimal or non-existent.
b) The company was trading below its book value (book value of $28.50/share vs. a market price of $21.50).
Hence liquidation the company represented the best means of delivering value to the company’s shareholders.
The transaction:
1) Identify opportunity2) Assess the accuracy of the treasurer’s book value estimate3) Estimate the probability that the liquidation will be approved.4) If deemed favourable through stages 2 and 3, buy Universal Marion Co. at or below its market price of $21.50/share.
2) Wait for company to be liquidated.

3) If liquidated, ROI = ~33%.

What ended up happening? “This company promptly made an initial distribution in cash and stock worth about $7 per share, reducing the investment to say $14.50/share. However the market price fell as low as $13/share subsequently, casting doubt on the ultimate outcome of the liquidation.” [27]

These examples aptly illustrate the risks and rewards inherent to “special situations”. Yet even those investors who are uncomfortable venturing into this more advanced terrain may still find opportunities worth exploring in this space, for failed acquisition offers may present attractive buying opportunities if they lead to excessive price declines. Indeed, in extreme cases such situations may be even more attractive than the original arbitrage opportunity, for there is no telling quite how heavily the market will discount the “failed” shares. As Graham put it, it is “Something for a security analyst to look into.” [28]

 

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] 376-377.
[2] 380.
[3] 380-381.
[4] 381.
[5] 381.
[6] 381.
[7] Those unfamiliar with the mechanics of a short sale may want to visit this site for a quick explanation. The video included at the end may also be helpful.
[8] 381.
[9] 381.
[10] 381.
[11] 381.
[12] 382.
[13] 383.
[14] Dan Strumpf, “U.S. Public Companies Rise Again,” The Wall Street Journal, February 5th 2014, http://online.wsj.com/news/articles/SB10001424052702304851104579363272107177430.
[15] This figure also reflects the requirement that only companies with a P/E ratio greater than 0.1 should be included. This was done to eliminate companies which do not have a P/E ratio in virtue of being unprofitable.
[16] 386.
[17] 386. Net tangible assets can be calculated as follows: Subtract intangible items such as goodwill and intellectual property from the company’s total assets. Then, subtract total liabilities. Expressed as an equation, Net Tangible Assets = (Total Assets – Intangible Assets) – Total Liabilities. For added caution, investors may also wish to subtract the value of all preferred stock.
[18] Data accurate as of July 11th, 2014.
[19] 391.
[20] Please keep in mind that, in doing so, I may inadvertently be providing inaccurate information. I do not know with certainty whether the steps depicted are truly consistent with what Graham had in mind; they are at best an educated guess and should be read with a grain of salt.
[21] 393.
[22] 395.
[23] 395.
[24] 393.
[25] 395.
[26] 394.
[27] 395.
[28] 395.

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