Introducing the Graham Enterprising Revised ScreenDownload printable PDF
Stock Investor Pro contains several screens based on Benjamin Graham’s popular intrinsic value approach. Most of our Graham screens have performed well, but the Graham Enterprising Investor screen suffered from a small universe of passing stocks. In the October 2012 AAII Journal, AAII President John Bajkowski discussed a method to adjust the Graham Enterprising Investor screen to allow for more passing companies while staying true to the methodology. The newly created screen not only allows for more passing companies, but the long-term performance is also better than the original screen, and the price volatility is lower.
The Graham Enterprising Revised screen can now be found in Stock Investor Pro as one of the predefined screens. The criteria for the Graham Enterprising Revised screen are detailed below, giving the rationale behind each filter in the screen. If a change was made to the original Graham Enterprising Investor screen, it is also noted below.
The primary valuation filter employed by Graham’s Enterprising Investor screen involves the price-earnings ratio—share price divided by earnings per share. Graham felt that one of the keys to selecting stocks is to purchase them at a significant discount. Graham’s first screen looked for companies trading with price-earnings ratios below nine or 10 times trailing earnings. As Graham thumbed through the S&P Stock Guide, he thought about one in 10 stocks would pass such a filter in late 1971. We took this cue to establish a filter that required a company’s price-earnings ratio to be among the lower 10% of all stocks.
While this criterion was not overly restrictive for the first three years that we ran the screen, it has proved to be too restrictive since 2001 when combined with the other criteria of the Enterprising Investor screen.
Our preference was to keep the filter as a percentage rank, which automatically adjusts the actual maximum as market valuation fluctuates. Stock Investor Pro tracks just over 9,800 companies. To calculate a valid price-earnings ratio, a company must have positive trailing earnings over the year. Currently, only around 4,200 have a meaningful price-earnings ratio. To have a price-earnings ratio among the lowest 10% of valid ratios, a company’s price-earnings ratio would need to be lower than 5.0.
We made a simple adjustment to allow companies with price-earnings ratios in the lowest 25% of stocks to pass the Graham Enterprising Investor screen. In today’s market, that translates to a price-earnings ratio of less than 10.0.
One warning that Graham gave of the low price-earnings filter was for 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. For these firms, Graham recommended constructing a price-earnings ratio using an average of earnings over the last three years. This type of analysis is used for the Defensive Investor screen.
As a test of short-term liquidity, Graham specified a current ratio (current assets divided by current liabilities) of 1.5 or higher.
To measure the use of long-term debt, Graham required that long-term debt not exceed net current assets, or working capital, by 110%. Working capital is defined as current assets minus current liabilities.
Graham liked to look at the historical company performance over an extended period of time. He had a preference for companies that avoided losses during recessionary periods. This would point to industries such as utilities, insurance, food processing, medical supply firms and pharmaceuticals.
For the Enterprising Investor screen, Graham specified that earnings be positive for each of the last five years. This type of screen can be very restrictive after an economic recession.
For the Enterprising Investor screen, Graham only specified that firms pay some level of current dividends—a simple filter that screens out two-thirds of the firms in Stock Investor Pro when used as a stand-alone criterion. As a rule, only more mature companies past their stage of strong, capital-intensive growth can afford to pay a cash dividend.
This filter will also cut out some stocks with low price-earnings ratios that are troubled and under financial duress.
When it came to earnings growth, Graham required only that earnings for the latest year be higher than earnings five years ago. Without such a criterion, a screen looking for companies with low multiples may list companies with poor prospects.
Graham was a believer in using low price-to-book-value ratios to select stocks, and he normally required a ratio below 1.5. For the Enterprising Investor screen, however, the criterion specified that the current price-to-book-value ratio be less than or equal to 1.2. Since Graham felt that secondary firms that might pass the filter normally trade at a discount to their intrinsic value, it is not surprising that a tougher filter was specified.
A percentile rank can also be used to specify the maximum price-to-book-value ratio. This would allow the screen to adjust dynamically to market conditions. We had success in specifying a maximum price-to-book percentile rank of 25—the lowest quarter of companies.
Adequate Size of Enterprise
Graham had a preference for large companies. He felt that large firms have the resources in “capital and brain power” to carry them through adversity and back to a level of satisfactory earnings. This concern came into play for Graham because he looked at stocks of firms that became unpopular due to unsatisfactory developments that were of a temporary nature. Graham also felt that the market responds more quickly with a price increase when an improvement is shown for a large firm than a small firm.
However, Graham made no requirements for minimum company size for his Enterprising Investor screen: Since he defines an enterprising investor as one with a high level of market experience and sufficient time and willingness to analyze stocks, he felt this type of investor could invest in “speculative” issues such as small stocks. We did, however, add a requirement that a company be listed on an exchange, and we are excluding foreign companies. These requirements help to ensure that audited financial statements are filed on a timely basis and the financials follow generally accepted accounting standards. These filters replace the requirement of a minimum share price of five dollars, which avoided “penny stocks.”
Further Information on Data Fields
For more details on any of these criteria as used in Stock Investor Pro, please visit the SI Pro Help menu.