With valuations for high quality businesses currently near or at an extreme, we thought we’d run a screen based on Graham’s Stock Selection Criteria to see if it produced any overlooked, inexpensive stocks. Ben Graham is regarded as the father of value investing, having authored Security Analysis and its friendlier sister publication Intelligent Investor. He’s also well known for his most famous pupil, Warren Buffett, and his ultra-conservative investments in ‘net nets’ or cigar butts, which were essentially stocks trading for less than their liquidation value.
Computers largely eliminated these opportunities decades ago, but I’m always reminded of Graham’s quote that if it hadn’t been for Geico, a low-cost car insurance company owned by Warren Buffett’s Berkshire Hathaway, which has been an incredible growth business, no one would’ve ever had of heard of him. ‘In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people’.
The key lesson for most investors is that if you buy the right business and hang on, your returns will be much better than looking for highly discounted, but low quality businesses.
Graham's 10 Criteria for stock selection are as follows:
1) An earnings-to-price yield at least twice the AAA bond yield.
There is plenty of research showing the benefits of paying low valuations for stocks, and this criterion shows the minimum premium Graham demanded for accepting the risks of owning shares over of bonds (back in the days when bonds were considered supremely safe).
In today’s environment, you need to be careful buying a stock on a 4% earnings yield (equivalent to a PER of 25) just because AAA bond yields are around 2%. You must ensure the absolute return is worth the risk. As Raymond DeVoe Jr. said, ‘More money has been lost reaching for yield than at the point of a gun.’
2) A price-earnings ratio less than 40% of the highest price-earnings ratio the stock had over the past five years.
This screen was also a value indicator, but you must understand why a company’s valuation has fallen, particularly with giants like Amazon looking for new industries to disrupt. The reported earnings number may not be representative of future cash or economic earnings, which could imply value or risk.
3) A dividend yield of at least two-thirds the AAA bond yield.
Studies of the US-listed Dividend Aristocrats have shown outperformance over certain periods, which makes intuitive sense as companies must have strong competitive positions to successively increase dividends over several decades. A higher dividend yield may suggest a bargain, but remember the old rule that the closer it gets to 10%, the closer it gets to zero.
4) Stock price below two-thirds of tangible book value per share.
Under normal circumstances this criterion, along with the following one, would suggest severe undervaluation provided you believed that book value, for example, which reflects the amount of money the company has invested in the business, is an accurate gauge of value.
Businesses are changing, though, with Buffett recently explaining that today’s technology giants, such as Google, don’t need capital to grow, unlike the captains of heavy industry typical during Graham’s career. Book value is not useful in these circumstances.
5) Stock price below two-thirds ‘net current asset value’.
See criteria four.
6) Total debt less than book value.
This criterion is making sure that a company’s financial position is sound, though there are numerous instances of high quality businesses and industries that can support higher gearing levels due to their stable revenues and pricing power.
7) Current ratio greater than two.
This criterion checks that a company can meet its short term financial obligations, but if you’re analysing a business it should be compared with its long-term financing for a fuller picture of a company’s creditworthiness. Same goes for criterion seven.
8) Total debt less than twice ‘net current asset value’.
See criterion seven.
9) Earnings growth of prior 10 years at least at a 7% annual compound rate.
Graham wanted everything from his investment candidates; a low valuation; a decent dividend yield; an unquestionable financial position; and reliable and respectable growth. As you’d imagine, it’s difficult finding this mix in today’s environment, but a history of steadily growing earnings can mean a company has a profitable competitive advantage.
10) Stability of growth of earnings in that no more than two declines of 5% or more in year-end earnings in the prior 10 years are permissible.
This last criterion helps avoid highly cyclical and weakly positioned businesses, where a company’s deteriorating financial position might lead to permanent losses of capital. You might need to apply some judgment here, though, as cycles are being extended by extreme monetary policies and there might be acceptable reasons for the falls in revenue.
Australian view: Just 2 stocks pass...
Graham’s stock selection criteria ask a lot in the current environment, though you’ll likely find more opportunities in the smallest nooks and crannies of the Australian stock market.
Only two Australian stocks survived our Ben Graham screen; Crown Resorts and Resolute Mining.
Crown Resorts is going through a transformation and may not be listed much longer if James Packer bids to take it private.
Resolute Mining currently has a lot of cash on its balance sheet, but the past earnings of miners are often unsustainable.
As you’d expect, the list is much longer when we look around the globe. You can see the list here: (VIEW LINK)
The 59 companies are mostly listed in Europe, Japan and Hong Kong. It’s quite common to find Japanese stocks trading on low multiples with huge cash balances, but reporting low return on equity.
This is usually a governance issue, where companies aren’t managed in the best interests of shareholders. This culture is slowly changing, so look for management teams that are adopting a more western style management approach, including increasing return on equity with shareholder friendly moves such as returning cash to shareholders.
We currently own some banks in the UK and Europe, which are trading on low price-to-book multiples with increasing dividends, and we own Chinese technology companies Tencent, Baidu and JD.com.
While none of these stocks conform to Graham’s selection criteria, one thing they have in common is a large insider owner in the form of their CEOs and founders. This provides a level of comfort that the businesses will be run for the long-term benefit of shareholders, although it’s not easy to measure like a financial ratio in Graham’s criteria.
A common conclusion from our results would be that Australians need more international diversification, which is reflected in the miniscule 1-2% of Self Managed Super Fund assets reportedly invested abroad. The Aussie dollar is up against some major currencies currently, but be careful with indexes and ETFs based on broad exposures of foreign stock markets.
The US looks fully, if not over-valued, for example, because of large stocks like McDonald’s, which sports a PER of 27, even though its profits haven’t budged since 2009. With the US market compounding at 17% annually since the bottom in March 2009, you should expect much lower returns in future. Individual stock selection will also be much more important over the next ten years than it has been since the GFC.
While we can learn from the successful investors of history, like Graham, you need to adapt to the current environment and know when to bend the rules. There are many stocks that boast wonderful financials currently, but will be roadkill for new competitors and/or technology in the decade to come. You can’t just rely on a company’s current financials, you need to understand where industries are headed, what returns they’ll produce and which companies will be victorious.
Lastly, the key lesson of any valuation exercise is the same one I always come back to. To achieve high returns, you need to be looking where others aren’t. It takes a contrarian streak to find value amongst unpopular stocks.
Now more than ever, the risk of owning a portfolio of the highest calibre businesses, particularly those helped the most by falling interest rates and increasing levels of consumer/mortgage debt, is at or near a cyclical peak.
In contrast to recent times, those with the best returns over the next ten years will likely own portfolios quite different to the large indexes. Or as Yale investor David Swensen put it:
"Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.’"
Or more simply, if you want better than average returns, you must do something different.
Nathan Bell is Head of Research at value-focused global fund manager, Peters MacGregor Capital Management. Peters MacGregor offers investors access to an undervalued portfolio of world class businesses with dominant market shares and bright prospects. Find out more here
Nathan has over 20 years' investment experience. Before joining Peters MacGregor, he worked for 9 years at Intelligent Investor, including 4 years as a Portfolio Manager. Nathan is a CFA charterholder
I’m a bit confused by this piece, according to Commsec the current financials for CWN mapped against the 10 Graham criteria are as follows: 1- Earnings to price twice the AAA bond yield; AUS 10 yr bond currently yields 2.59%, x 2 = 5.18% or a PE of 19.3. CWN current period P/E is 22.7. Fail. 2 – Current P/E < 40% of max P/E over the past 5 years; Highest average P/E for CWN over the last 5 years was 22.8 in 2015 v current P/E of 22.7 – basically CWN is currently trading around it’s highest annual P/E in the last 5 years. Fail. 3- Dividend yield 2/3s of AAA bond; at 6.8% CWN easily yields > 2/3s of 2.59%. Pass. 4- Price below 2/3s of NTA (P/B = .67); CWN current P/B ratio 1.77. Fail. 5- Price below 2/3 of Net Current Assets value; CWN Total Current liabilities exceeded Current Assets as of 2016. Fail. 6-Total Debt less than book value; debt of $881m v $6.69bn. Pass. 7- Current ratio greater than 2; CWN current ratio .96. Fail. 8- Total debt < 2x Net Current Assets; Total current Liabilities exceed Current Assets as of 2016. Fail. 9- Compound earnings growth > +7% p/a over 10 years; CWN EPS 2007 50.4c, 2016 54.0c. Fail. 10- Earning growth declines of > 5% no more than 2 times over last 10 years; CWN EPS dropped greater than 5% in 2009 (-28%), 2015 (-30%) & 2016 (-12%). Fail. By my reckoning that’s a 2 out of 10 pass rate, not quite a lay down misère. My understanding of Graham was that he was particularly concerned with liquidation value hence the focus on cash and current assets - liabilities outweighing the price. It’s a todays toppy markets we would be very unlikely to see that in an ASX200 stock.
Hey Livewire editors, all my formatting from my preceding comment has been lost making it very difficult to follow, can you reformat it?
Hi Mark, unfortunately we don't have any formatting option in the current comments field (feedback noted) . I'll drop you an email and follow up on your question with Nathan to see if we can get you a response. James
Hi Mark. Whenever you perform a screen like this you need to double-check the numbers with the source documents (i.e. the company accounts). Without doing the requisite work I had assumed Crown popped up because it was flush with cash after the Macau assets were sold (again, I haven't checked this). Nonetheless, your conclusion is spot on. It's highly unlikely you'd find a well known, large-cap stock meeting Graham's criteria. That's probably been the case for decades outside periods of panic like the GFC for several reasons (including Graham's criteria simply being too restrictive in modern markets). You might find more examples amongst micro-caps, but they often have little liquidity and investing services and investors are also screening for these ideas, so it's competitive. Markets are far more efficient today compared to Graham's times, as software didn't exist to do the hard work for him. There were also far fewer investors and hedge funds around back then. Cheers Mark.