Wayne Thorp recently spoke at the 2017 AAII Investor Conference. For information on how to subscribe to recordings of the presentations, go to www.aaii.com/conferenceaudio for more details.
The roots of modern day value investing are often traced back to Benjamin Graham.
Graham’s own approach to investing focused on the concept of an intrinsic value that is justified by a firm’s assets, earnings, dividends, and financial strength. Focusing on this value, Graham felt, would prevent an investor from being misled by the misjudgments often made by the market during periods of extreme euphoria or deep pessimism.
For stock investors seeking an approach to guide them through today’s stormy markets, Graham’s screens for defensive investors are worth a closer look.
Graham felt that it was difficult for individual investors to “beat the market” just by finding stocks that will grow faster than the overall long-term market average.
As Graham saw it, the problem for investors is twofold: First, even stocks with obvious growth prospects don’t always translate into extra profits for an investor because those prospects are already reflected in the price of the stock; secondly, there is the risk that the investor will be wrong about the firm’s growth prospects. Graham felt that this risk is accentuated by the psychology of the stock market, which could mislead investors into overvaluing or undervaluing a stock.
Instead of trying to select stocks just for growth potential, Graham first focused on determining an “intrinsic” value for a stock that is independent of the market. However, he admitted that arriving at such a value requires considerable investment judgment. He felt that a firm’s tangible assets were a particularly important component, along with earnings dividends, financial strength, and stability. Graham felt investors should limit their purchases to stocks not selling far above this value, while stocks selling below their intrinsic value would offer an even better margin of safety to investors.
Graham defined defensive investors as those investors unable to devote much time to the process or those who are as-yet unfamiliar or inexperienced with investing. As such, Graham felt defensive investors should confine their holdings to the shares of “important” companies with long histories of profitable operations that are in a strong financial condition. By “important,” he meant a firm of substantial size and with a leading position in its respective industry, ranking at least in the top third in size among its industry group.
Based on the principles outlined in “The Intelligent Investor,” AAII developed the Graham Defensive Industrial and Defensive Utility screens. These screens look for companies of adequate size (based on annual sales) with:
The specific screening criteria for the Graham screens are listed at the end of this article.
The two Graham screens discussed here (as well as a screen based on his aggressive investor approach) are built into AAII’s Stock Investor Pro fundamental stock screening and research database program. Furthermore, the companies passing these screens are posted each month on AAII.com, and the performance of stocks held in the hypothetical portfolios is tracked on-line.
Figure 1 shows the performance of the Graham screens. Both have managed to outperform the overall market since we began backtesting the screens at the beginning of 1998.
Like most stock investing methodologies, the Graham screens have had a rough go of things during the recent market downturn. The Graham Defensive Industrial (Non-Utility) approach has generated a cumulative return of almost 270% between January 1998 and the end of March 2009, while the S&P 500 was down almost 18%.
The Defensive Utility approach had a gain of 114.6%. While this screen has not performed as well as the Industrial screen, it is notable in that it has outperformed the S&P 500 despite being less volatile in terms of the monthly deviation in price.
The characteristics of the stocks currently meeting the criteria of the Graham Defensive Industrial (Non-Utility) and Defensive Utility screens are presented in Table 1.
|Portfolio Characteristics (Median)||
|Price-earnings ratio (X)||9.3||11.9||12.8|
|Price-to-book-value ratio (X)||1.5||1.4||1.1|
|Dividend yield (%)||2.4||4.9||0.0|
|EPS 5-yr. historical growth rate (%)||23.2||6.7||4.2|
|EPS 3-5 yr. estimated growth rate (%)||11.4||6.3||12.0|
|Market cap. ($ million)||1257.3||2415.4||233.9|
|Relative strength vs. S&P (S&P=0) (%)||-6||24||-10|
|Average no. of passing stocks||19||16|
|Highest no. of passing stocks||62||38|
|Lowest no. of passing stocks||1||5|
|Monthly turnover (%)||21.0||15.4|
|Data as of April 10, 2009.|
Table 2 lists the companies passing the Graham Defensive Industrial and Utility screens that have the 10 lowest price-earnings ratios. Currently, 51 companies pass the Defensive Industrial screen and 36 pass the Defensive Utility screen. These screening results are as of April 10, 2009.
Historically, the Defensive Industrial screen has had, on average, 19 companies pass each month, while the Defensive Utility screen has averaged 16.
Currently, the companies passing the Graham screens have median price-earnings ratios that are lower than the typical exchange-traded stock.
In order to pass either of the Graham Defensive screens, the product of a company’s price-earnings ratio and price-to-book-value per share ratio cannot be higher than 30.0. We arrive at this value by multiplying the maximum price-to-book-value per share ratio of 1.5 by the maximum price-earnings ratio of 20.
|Company (Exchange: Ticker)||
|Graham Defensive Industrial (Non-Utility)|
|Ensco Int’l (N: ESV)||3.6||4.5||0.9||28.7||0.3||3.3||4152.5||39||offshore drilling|
|Advance Amer Cash Adv (N: AEA)||4.4||3.6||0.9||3.6||9.6||4.9||160.3||27||cash advance servs|
|Spartan Motors (M: SPAR)||4.4||6.7||1.1||27.0||1.7||2.6||189.3||69||custom vehicles|
|Yanzhou Coal Mining (ADR) (N: YZC)||5.3||10.5||1.2||17.0||2.8||2.5||4338.1||58||coal mining|
|Tidewater Inc. (N: TDW)||5.6||7.5||1.0||22.5||2.4||3.0||2151.2||74||marine support|
|Baker Hughes (N: BHI)||5.8||5.4||1.4||22.5||1.9||2.8||9565.9||39||oilfield servs|
|Nam Tai Electron (N: NTE)||5.9||3.8||0.6||11.2||21.8||2.7||181.0||36||electronics|
|Timken Co. (N: TKR)||6.0||7.2||1.0||29.2||4.3||2.5||1620.4||50||steel & bearings|
|Ennis, Inc. (N: EBF)||6.2||6.0||0.7||11.5||6.3||3.5||256.2||59||business forms|
|Sasol Limited (ADR) (N: SSL)||6.3||10.6||1.9||18.8||1.6||2.4||19934.9||56||energy & chem|
|Graham Defensive Utility|
|Energen Corp. (N: EGN)||7.1||7.6||1.2||85.3||1.6||1.3||2277.7||43||energy holding co.|
|ONEOK, Inc. (N: OKE)||8.2||8.6||1.2||24.1||6.6||0.8||2549.3||47||diversified energy|
|DTE Energy Co. (N: DTE)||8.9||8.6||0.8||7.0||7.3||1.1||4715.3||72||energy & related|
|FirstEnergy Corp. (N: FE)||9.2||9.7||1.5||6.4||5.5||0.4||12257.4||52||energy holding co.|
|AGL Resources (N: AGL)||9.4||9.7||1.2||30.1||6.4||1.0||2058.2||77||energy serv hold co.|
|Dominion Resources (N: D)||9.6||9.7||1.8||16.5||5.7||1.0||17784.6||70||prod & trans energy|
|OGE Energy (N: OGE)||9.9||9.8||1.2||10.9||5.8||0.8||2343.3||77||electric & natural gas|
|UGI Corp. (N: UGI)||10.0||12.5||1.8||17.8||3.3||1.0||2487.5||85||energy holding co.|
|Avista Corp. (N: AVA)||10.4||12.0||0.8||-0.2||5.1||0.7||774.3||71||energy & related|
|Sempra Energy (N: SRE)||10.4||10.8||1.4||8.5||3.4||0.7||11283.5||82||energy serv hold co.|
|Exchange Key: M = NASDAQ; N = New York Stock Exchange.|
|Source: AAII’s Stock Investor Pro/Reuters Research, Inc. Data as of April 10, 2009.|
As a proxy for the maximum price-earnings ratio, Graham used the inverse of 10-year AA corporate bond rates. He felt that, at a minimum, defensive investors should establish a portfolio whose earnings yield—the inverse of the price-earnings ratio—was at least comparable to the yield on 10-year AA bonds. Therefore, the current price-earnings ratio of 20 used in the Graham Defensive screens is the inverse of the 10-year AA corporate bond rate of 5% (1 ÷ 0.05 = 20).
Taking the maximum price-earnings ratio of 20 and multiplying it by the maximum price-to-book-value per share value of 1.5 gives us the hurdle level of 30 (1.5 × 20). So a stock selling at 2.5 times book value could not be selling at any more than 12.0 earnings in order to pass the screen (12.0 × 2.5 = 30.0).
Ensco International ESV has the lowest price-earnings ratio among all Graham Defensive stocks. The company engages in the drilling of offshore oil and gas wells and has seen its stock price decline along with the price of oil. The stock recently traded at $29.28, almost 65% off its 52-week high, and it has trailing 12-month earnings of $9.17 per share.
Both the Graham Defensive screens require a history of positive earnings for each of the last seven years. Graham also wanted to see defensive companies grow their earnings per share by at least one-third over the last 10 years, for an annual average increase of 2.9%. Therefore, the Graham Defensive screens also require an average annual growth in earnings per share of at least 3% over the last seven years. These requirements pushed the median growth rates for the companies passing these two screens above that of the typical exchange-listed stock. The stocks passing the Graham Defensive Industrial screen have seen earnings grow at an average rate of 23.2% over the last five years.
As mentioned earlier, Graham suggested that defensive investors invest only in “important” companies—those of substantial size. For defensive industrial companies, Graham used annual sales as a proxy for company size, since sales are insulated from market-driven measures such as market capitalization.
For utilities, Graham used assets as a proxy for company size. Ultimately, he chose to avoid small companies and to instead focus on “important companies” with leading positions in their industry. This is reflected in the median market cap levels for the companies passing the Defensive Industrial and Defensive Utility screens—$1.3 billion and $2.4 billion, respectively. The market cap range for the Defensive stocks range from $160.3 million for Advance America Cash Advance AEA to almost $18 billion for electric utility Dominion Resources (D).
Looking at price performance relative to the S&P 500, we see that the companies currently passing the Graham screens have had mixed results over the last year. The Graham Defensive Utility stocks have fared the best, as their median performance surpasses that of the S&P 500 by 24%. Meanwhile, the Defensive Industrial companies have underperformed the S&P 500 by 6% over the last 52 weeks.
Graham summarized his own philosophy by stating that intelligent investing consists of analyzing potential purchases according to sound business principles.
“You are neither right nor wrong because the crowd disagrees with you,” he said. “You are right because your data and reasoning are right. In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”
Defensive Industrial (Non-Utility):
*We adjust the maximum price-earnings ratio to reflect changes in the level of market rates, as represented by the 10-year AA corporate bond yield.
**We adjust the maximum price-earnings ratio to reflect changes in the level of market rates, as represented by the 10-year AA corporate bond yield, which impacts the maximum allowable price-earnings ratio multiplied by price-to-book ratio for the screen.