My Key Takeaways From Chapter 14 and Commentary 14 of the Intelligent Investor. Part 14/16. To Be Continued.

Chapter 14 Stock Selection for the Defensive Investor

In setting up this diversified list he has a choice of 2 approaches, the DJIA-type of portfolio and the quantitatively tested portfolio.
In the first he acquires a true cross-section sample of the leading issues, which will include both some favored growth companies, whose shares sell at especially high multipliers, and also less popular and less expensive enterprises. This could be done, most simply perhaps, by buying the same amounts of all 30 of the issues in the DJIA.
His second choice would be to apply a set of standards to each purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price. At the close of the previous chapter we listed 7 such quality and quantity criteria suggested for the selection of specific common stocks. Let us describe them in order.

1. Adequate Size of the Enterprise
Let us use round amounts: not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.

2. A Sufficiently Strong Financial Condition
For industrial companies current assets should be at least twice current liabilities-a so-called two-to-one current ratio. Also, long term debt should not exceed the net current assets (or “working capital”). For public utilities the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability
Some earnings for the common stock in each of the past 10 years

4. Dividend Record
Uninterrupted payments for at least the past 20 years.

5. Earnings Growth
A minimum increase of at least one-third in per-share earnings in the past 10 years using 3-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past 3 years.

7. Moderate Ratio of Price to Assets
Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.
Our basic recommendation is that the stock portfolio, which acquired, should have an overall earnings/price ratio-the reverse of the P/E ratio-at least has high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.

Selectivity for the Defensive investor

Suppose, as a practical test, we had asked a hundred security analysts to choose the “best” five stocks in the Dow Jones Average, to be bought at the end of 1970. Few would have come up with identical choices and many of the lists would have differed completely from each other. This is not so surprising as it may at first appear. The underlying reason is that the current price of each prominent stock pretty well reflects the salient factors in its financial record plus the general opinion as to its future prospects. Hence the view of any analyst that one stock is better buy than the rest must arise to a great extent from his personal partialities and expectations, or from the placing of his emphasis on one set of factors rather than on another in his work of evaluation. If all analysts were agreed that one particular stock was better than all the rest, that issue would advance to a price which would offset all of its previous advantages.

With the increasing impact of technological developments on long-term corporate results, the investor cannot leave them out of his calculation. Here, as elsewhere, he must seek a mean between neglect and overemphasis.

Commentary on Chapter 14

“He that reseth upon gains certain, shall hardly grow to great riches; and he that puts all upon adventures, doth oftentimes break and come to poverty: it is good therefore to guard adventures with certainties that may uphold losses.” – Sir Francis Bacon

Testing, Testing

Let’s briefly update Graham’s criteria for stock selection.

1. Adequate Size
Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion.

2. Strong Financial Condition
Graham’s criterion of financial strength still works: If you build a diversified basket of stocks whose current assets are at least double their current liabilities, and whose long-term debt does not exceed working capital, you should end up with a group of conservatively financed companies with plenty of staying power.

3. Earnings Stability
So Graham’s insistence on “some earnings for the common stock in each of the past 10 years” remains a valid test-tough enough to eliminate chronic losers, but not so restrictive as to limit your choices to an unrealistically small sample.

4. Dividend Record
As of early 2003 according to S&P’s, 354 companies in the S&P 500 (or 71% of the total) paid a dividend. No fewer than 255 companies have paid a dividend for at least 20 years in a row.

5. Earnings Growth
How many companies in the S&P 500 increased their earnings per share by “at least one third,” as Graham requires, over 10 years ending in 2002? (We’ll average each company’s earnings from 1991 to 1993, and then determine whether the average earnings from 2000 through 2002 were at least 33% higher.) According to Morgan Stanley, 264 companies in the S&P 500 met the test. But here, it seems, Graham set a very low hurdle; 33% cumulative growth over a decade is less than 3% average annual increase. Cumulative growth in earnings per share of at least 50%-or a 4% average annual rise-is a bit less conservative. No fewer than 245 companies in the S&P 500 index met that criterion as of early 2003.

6. Moderate P/E Ratio
The prevailing practice on Wall Street today is to value stocks by dividing their current price by something called “next year’s earnings.” That gives what is sometimes called “the forward P/E ratio.” But it’s nonsensical. Over the long run, money manager David Dreman has shown, 59% of Wall Street’s “consensus” earnings forecasts miss the mark by a mortifyingly wide margin, either underestimating or overestimating the actual reported earnings by at least 15%. Instead, calculate a stock’s price/earnings ratio yourself, using Graham’s formula of current price divided by average earnings over the past 3 years.

7. Moderate Price-to-Book Ratio
*In recent years, an increasing proportion of the value of companies come from intangible assets like franchises, brand names, and patents and trademarks. Since these factors (along with goodwill from acquisitions) are excluded from the standard definition of book value, most companies today are priced at higher price-to-book multiples than in Graham’s day. According to Morgan Stanley, 123 of the companies in the S&P 500 (or one in four) are priced below 1.5 times book value. All told, 273 companies or (55% of the index) have price-to-book ratios of less than 2.5.

What about Graham’s suggestion that you multiply the P/E ratio by the price-to-book ratio and see whether the resulting number is below 22.5? Based on data from Morgan Stanley, at least 142 stocks in the S&P 500 could pass that test as of early 2003. So Graham’s “blended multiplier” still works as an initial screen to identify reasonably-priced stocks.

Due Diligence

1. Do your homework
Through the EDGAR database at www.sec.gov you get instant access to a company’s annual and quarterly reports, along with proxy statement that discloses the managers’ compensation ownership, and potential conflicts of interest. Read at least 5 years’ worth.

2. Check out the neighborhood
Websites like http://quicktake.morningstar.com, http://finance.yahoo.com, and www.quicken.com can readily tell you what percentage of a company’s shares are owned by institutions. Anything over 60% suggests that a stock is scarcely undiscovered and probably “over owned.” (When big institutions sell, they tend to move in lockstep, with disastrous results for the stock.