by Joe Lan, CFA
Benjamin Graham is famously called the father of modern value investing. His investment methodology is based on fundamental analysis, seeking companies that are undervalued. He introduced the concepts of security analysis and intrinsic value. In fact, Warren Buffett, one of the greatest investors of our time, credits Benjamin Graham with being one of his strongest investing influences.
AAII currently follows three separate Graham screens based on Benjamin Graham’s methodologies as described in his book, “The Intelligent Investor” (revised edition: Collins Business, 2003). Each of these screens has performed well over the long run. However, the Graham Enterprising Investor screen typically has very few companies that pass its filters each month, and often no companies pass the screen at all. To address this weakness and make the screen more investable, AAII President John Bajkowski revised the Graham Enterprising Investor screen. His efforts can be found in the October 2012 AAII Journal (available at AAII.com).
The Graham Enterprising Revised screen not only allows more companies to pass than the original Graham screen, but the long-term performance has also been better. However, the revised screen is not currently programmed into Stock Investor Pro, AAII’s fundamental stock screening and research database. In this Feature article, I provide step-by-step instructions on creating the Graham Enterprising Revised screen. The screen will be built using Stock Investor Pro, but you can use any stock screening tool you prefer.
Before we begin, let’s review the methodology behind the Graham Enterprising screen.
The Enterprising Investor
Benjamin Graham felt that individual investors fall into two camps: defensive investors and aggressive, or enterprising, investors. These two groups are distinguished not by the amount of risk they are willing to take, but rather by the amount of “intelligent effort” they are “willing and able to bring to bear on the task.”
For instance, he included in the defensive investor category professionals unable to devote much time to the process and young investors (his example was a sharp young executive interested in finance) who are unfamiliar and inexperienced with investing. Defensive investors should confine their holdings to larger companies with a long record of profitable operations and that are in strong financial condition.
Graham believed that aggressive investors, on the other hand, can expand their universe substantially. Being a proponent of value investing, though, Graham recommended that purchases should be attractively priced as established by intelligent analysis. He also stated that even aggressive investors should avoid new issues.
In “The Intelligent Investor,” Benjamin Graham defined the enterprising investor as an individual experienced in investing who is willing and able to put forth an “intelligent effort” in analyzing a wide range of seasoned stocks. Graham noted that there are several “fertile” areas on which investors should focus to find undervalued stocks for enterprising investors.
The first area is large, out-of-favor companies, indicated by a low price relative to current earnings. While small companies may also be undervalued, Graham felt they carry a much greater risk that they would not be able to sustain themselves through a period of adversity. In addition, he believed that the market’s neglect of small firms results in slow recognition of better earnings, extending the period of unpopularity. It is also important to recognize the difference between a company that is truly trading at a discount and a cyclical firm that has a low current price-earnings ratio because it is in a peak year. The market recognizes that the price-earnings ratios of these latter companies will rise as earnings drop during weaker years. To avoid buying these cyclical firms, he suggested searching for companies that are trading at a low price in relation to past average earnings.
Separately, Graham recommended seeking bargain stocks, which he defined as stocks selling at 50% or less of their “indicated” value. Indicated value can be calculated either by estimating future earnings or by valuing the firm as a private business, which includes an estimate of future earnings and places emphasis on the value of realizable assets, particularly working capital less debt. The most obvious bargain, according to Graham, is a company selling for less than its net working capital alone. In this case, Graham said that the investor would be purchasing a firm without paying for its plants and machinery or any intangibles.
Once again, Graham stressed the necessity for investors to distinguish between undervalued stocks and those that are selling at low prices relative to value for a reason. Graham suggested that aggressive investors also look for reasonable stability of earnings over the past decade, with no years of negative earnings and enough financial size and strength to allow the firm to survive any future setbacks.
According to Benjamin Graham, enterprising investors could also find success investing in “secondary companies,” if their shares are purchased at bargains. Graham defined a secondary company as one that is a smaller concern in an important industry or a top firm in an unimportant industry. He noted that mid-sized companies fit this definition and he felt the stock market tends to undervalue these firms. At the same time, he believed these firms are large enough to sustain themselves through various economic cycles, with the ability to earn a fair return on invested capital. Investors would profit from both earnings paid in dividends and those that are reinvested. He also noted that during bull market periods, these firms generally return to fair valuation.
Creating the Revised Screen
Figure 1 shows the criteria for the original Graham Enterprising screen, as programmed into Stock Investor Pro. A few significant changes were made to the screen to create a larger list of passing companies while maintaining the characteristics of Benjamin Graham’s methodology. The following section dissects each portion of the Graham Enterprising screen, explains the changes made to revise the screen and creates the screen in Stock Investor Pro.
The foundational belief of Graham’s methodology is to select stocks trading at a significant discount. In the original Graham Enterprising screen, the first criteria used is that companies passing must be in the bottom 10% of all stocks based on price-earnings ratio. As stated earlier, Graham warned about the low price-earnings filter passing cyclical firms with widely fluctuating earnings. These firms often trade at high prices and low price-earnings ratios in good years when they should be sold and low prices and high or non-existent price-earnings ratios in bad years when they should be considered for purchase. Graham recommended a test of low price relative to past average earnings, which is used for the defensive investor screen.
For the revised Graham Enterprising screen, we kept the filter as a percentage rank so that the figure will adjust as the market fluctuates. Naturally, this filter is very restrictive, as more than 90% of all stocks will immediately be screened out. To adjust this filter in the revised Graham Enterprising screen, we screened for stocks with a price-earnings ratio in the bottom 25% of all stocks.
For the enterprising investor, Graham stipulated that the current ratio must meet or exceed 1.5, while long-term debt is not to be higher than 110% of working capital.
The current ratio is calculated by dividing current assets by current liabilities, while working capital is defined as current assets minus current liabilities. These filters remain unchanged for the revised screen.
Graham required that companies have a long history of earnings stability. For the enterprising investor, Graham specified that earnings must be positive for the last five years.
During recessionary periods, this screen may become very restrictive, passing mostly firms from defensive industries. However, we have yet to find this filter overly restrictive. Therefore, the filter was not changed for the Graham Enterprising Revised screen.
As far as dividends go, Graham required only that firms pay some level of current dividends. As you can see from Figures 1 and 2, this filter passes a little over 3,000 stocks by itself. Typically, only more mature companies past their stage of strong, capital-intensive growth can afford to pay a cash dividend.
This filter is also designed to screen out companies with low-price earnings ratios that are under financial distress. Since this filter is not overly restrictive, it is kept the same in the revised Graham screen.
For enterprising investors, Graham stated that current earnings should be higher than they were five years ago. This simple filter passes around half of the universe of stocks and is kept the same in the revised Graham screen.
A final measure of value used by Graham is the price-to-book-value ratio. For the enterprising investor, Graham specified that firms should have a price-to-book-value ratio of 1.2 or lower. This filter allows for about 3,000 or so companies to pass, and it was kept the same for the revised screen.
Exchange-Traded & Domestic
Although Graham preferred larger companies as investments due to their ability to weather economic adversity, he felt that enterprising investors could invest in more speculative issues, such as smaller stocks. Therefore, there is no requirement for company size. For the revised screen, however, we did add requirements that stocks must be exchange-listed and traded domestically. These requirements are meant to ensure that audited and timely financial statements are available for the passing companies.
Historical Comparison of Screens
The goal of the Graham Enterprising Revised screen is to allow for more passing companies while maintaining Benjamin Graham’s vision for enterprising investors. As shown at the bottom right of Figures 1 and 2, we successfully increased the number of passing companies from one to four. In addition, the monthly turnover of the screen has been reduced from 44% to 26%.
Table 1 reports the annual return and risk characteristics of the two Graham Enterprising screens, which shows that the revised screen outperforms the original screen over the long term. The revised screen also performed much better during the last bull market than the original screen, while during the last bear market the two screens were nearly identical. Standard deviation is also nearly the same for the two screens. Additionally, it should be noted that in 2008 the revised screen had much better downside protection.
Using Stock Investor Pro with data as of November 23, 2012, four companies passed the Graham Enterprising Revised screen, whereas one company passed the original screen. The passing companies for both screens, along with their fundamental data, are listed in Table 2. Table 3 lists the criteria used specfically in Stock Investor Pro.
The lone passing company for the original Graham Enterprising screen is Orient Paper Inc. (ONP), a Chinese company that no analysts compiled by I/B/E/S track. This company has a market capitalization of $38.2 million. Although the price-earnings and price-book ratios are very low, it is difficult to say that this company truly meets the essence of Benjamin Graham’s screen. The company is very small and may be overlooked by investors for some period of time, causing a prolonged slump in price even if its prospects improve.
The Graham Enterprising Revised screen passed four stocks from four separate industries. Three of the four stocks are trading at lower price-earnings ratios than their seven-year historical averages and all four of the stocks are trading at lower price-to-book-value ratios than their seven year averages. AMCON Distributing Co. (DIT) and Friedman Industries (FRD) are small, with market capitalizations of less than $68 million, but Mantech International Corp. (MANT) and Western Digital Corp. (WDC) are larger companies, with market capitalizations of $900 million and $8.5 billion, respectively.
|Data Category||Conn||Field||Compare to (Field, Value, Indus)|
|Company Information||Exchange||Not Equal||Over the counter|
|Company Information||And||Country||Equals||United States|
|% Rank||And||% Rank-PE||<=||25|
|Ratios||And||Current ratio Q1||>=||1.5|
|Ratios||And||LT Debt/working capital Q1||<=||110|
|Income Statement - Annual||And||EPS 12m||>||0|
|Income Statement - Annual||And||EPS Y1||>||0|
|Income Statement - Annual||And||EPS Y2||>||0|
|Income Statement - Annual||And||EPS Y3||>||0|
|Income Statement - Annual||And||EPS Y4||>||0|
|Income Statement - Annual||And||EPS Y5||>||0|
|Income Statement - Annual||And||Dividend, indicated||>||0|
|Income Statement - Annual||And||EPS 12m||>||EPS Y5|
|Income Statement - Annual||And||EPS Y1||>||EPS Y5|
Benjamin Graham once said that individuals who cannot master their emotions are ill-suited to profit from the investment process. As a value investor, he understood that good companies do not always make good stocks. His goal was to purchase strong companies at a discount to their intrinsic value.
The newly established Graham Enterprising Revised screen is a less-restrictive screen, while identifying companies that have performed well over the long run and maintaining the spirit of Benjamin Graham’s methodology.
Always keep in mind, though, that stock screening should be the beginning of the investment process. Be sure to perform due diligence when using a stock screen to ensure that the stocks you purchase match your personal risk-aversion and time horizon. Be careful with deep-value screens: Companies may be out-of-favor with investors for good reason.