There comes a time in any young Fool's life when the fledgling investor must struggle through Benjamin Graham's classic tome, The Intelligent Investor.
I can hear the voices now. "Struggle? What are you, some kind of heretic? This is the value investor's Bible! You'd better pay attention, pal. When I was your age."
If the diatribe sounds familiar, it's because we hear it more and more often these days. We do a fair amount of grousing about value here, both in articles and on the public boards. In fact, I was at the business end of one of these grandfatherly scoldings not so long ago on a Fool board. With the market appearing to have weathered its first post-bubble bubble late last month, the herds seem convinced an economic recovery is on the horizon; the contrarians and value folks tend to scream more loudly about the rich multiples being assigned to the market. As debaters often will do, authority is invoked to shore up support for arguments. And in the value school, Graham is the granddaddy of all authorities.
But there's the trouble. Even a congenital cheapskate like me finds it a bit tough to stomach Graham, especially those sections on bonds. (Zzzzz.) Skipping to the section on stocks and reading the 2003 version with commentary by Jason Zweig is somewhat easier. It allows us to engage in some dot-bomb 'n' bubble schadenfreude as Zweig contrasts the folly of the late '90s "greater fool" investing (little f) with Graham's time-tested approach to digging up value. But even so, sometimes the only way I can keep from nodding off is to imagine the book is being read to me by The Simpsons' Mr. Burns. But enough of my delusional motivation tactics.
Setting the bar
The point here is that the benchmarks by which Graham judged stocks often seem hopelessly outdated. Take his most conservative approach for judging stocks suited to the portfolio of the "defensive" investor. Price-to-earnings ratio under 15? No negative earnings -- my people call them "losses" -- for 10 years? Uninterrupted dividends for 20 years? (Investors under 50 years old might wonder, "What the heck is a dividend, anyway?")
Every time I go over Graham's chapter 14, I wonder, "Do stocks like these even exist any more?"
That is what I set out to discover last week while I was waiting for the new kitchen tile to set. One easy way to do this, of course, is to simply use online screening tools, which we write about with some regularity here at the Fool. (For some nuts-and-bolts basics on screening, read what Selena Maranjian had to say in February.)
Now, as mentioned in those articles linked above, there are some pre-fab Graham screens out there that will serve up ideas filtered by Graham-ish criteria, though some of them keep you in the dark about criteria until you pay up. For the record, I was not interested in finding stocks that match someone else's interpretation, however useful, of Graham's concepts of intrinsic value. These are open to more interpretation. I wanted to see if there was anything out there that met his standards, or a very reasonable version thereof, plain and simple.
I used the handy, free Java screenertool provided by Yahoo! (NASDAQ:YHOO) Finance. Microsoft's (NASDAQ:MSFT) Money site has another freebie. The two offer somewhat different selection conditions, and neither can be tweaked to match Graham's criteria exactly, but both can narrow the field enough that you can check the other standards individually, if necessary.
Graham's Defensive Investor Screen
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Size matters. Graham was looking for companies with at least $100 million in sales. This was his most arbitrary figure, meant to exclude smaller companies. Since many smaller companies book sales of $100 million these days, we'll take Zweig's suggestion and limit the size by market capitalization, nothing less than $2 billion. (1,198 stocks pass this test.)
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Liabilities on the down-low. Graham was looking for twice as much in current assets as current liabilities. So, we set the screen's current ratio to two or better. Graham also demanded that long-term debt be less than net current assets. This is tougher to set in the screen, but we can strain out high-debt companies later. (Only 285 remain after this one.)
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Earnings, please. Graham is vague here. He wanted "some earnings for the common stock in each of the past 10 years." We can't check this directly with the screen, but we can see if earnings are growing. Graham also looked for earnings growth of at least 33% over 10 years. Our Yahoo! Screener lets us look for earnings growth over the last five years, so let's set the bar low at 16% over that period. (63 stocks left.)
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Don't forget the dividend. The screener doesn't give us the option of searching back more than five years, which we'd need to do in order to meet Graham's insistence on a 20-year record. Instead, we can set the dividend field to a nominal current yield, say 0.5%, and check on the consistency later. (13 lucky stocks remain.)
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Price must be right. Graham didn't want to pay any more than 15 times average earnings for the past five years. We can only screen for a current P/E of 15 or less, though we can tweak this up a stitch later if we want.
- Price must be right, part 2. Graham was also looking for firms with a price-to-book value ratio of 1.5 or less.
And the winner is.
Nobody. That's right, not a single stock meets all of Graham's defensive criteria. Score one for the book-screaming skeptic.
Notice how I stopped with the update on the remaining stocks after step five? That's because none of the 13 stocks that made it through step four trades at Graham's target P/E ratio. If we bump it up to 20, five stocks are left, but still, none of them pass step six, Graham's price-to-book of 1.5 or less.
As Zweig notes in the updated version of the book, today's market has a much different idea of the value of assets like brand names and intellectual property. This makes it pretty tough to find companies priced below 1.5 times book value. If we pump that number up to two, we still get bupkis. Even when we raise the price-to-book ratio to three, we end up with only three companies. Oddly enough, none of them seems to fit with the stereotypical notion of a low P/E Graham industrial.
So which stocks are the lucky three?
Foot Locker (NYSE:FL) is a name that's familiar to just about anyone. Lately, we've been focusing on stiff competition in the sporting-goods industry and the flap with Nike (NYSE:NKE), but with a possible reconciliation on the horizon, it may be a good time to review this stock.
Speaking of shoes, Reebok (NYSE:RBK) has been a Fool favorite for the past couple of years, and continues to build a strong presence in both athletic shoes and in hip footwear for the masses.
Rounding out the three survivors is the crafty Michaels Stores (NYSE:MIK). This is one of those solid performers I've often noticed in my neighborhood, because the parking lot stays pretty full. It had a record year for 2003 and recently lifted its first-quarter outlook.
The moral of the story
We don't have to throw Graham out the window just because we can't find any stocks that currently meet his criteria for defensive investing. Sure, there are plenty of investors, like Buffett, who agree with the results of our screen, and think that right now nothing looks good, so sitting on your hands might be the best decision. Of course, by tweaking the screen, as we did above, we find companies that come close, and we can wait to see if the panicky market offers up a better price one of these days.
But in the end, the Graham experience is about more than just digging up investment ideas. It's about context and perspective. Over your investment career, you'll be much better at spotting bargains -- even if you invest more aggressively than the stodgy, weathered pros -- if you know how those dusty authorities found value the old-fashioned way.
What now?
Screening can be fun, but it can also be a lot of work. If you'd like to take a look at plenty of investment ideas each month, pre-screened by the Fool's crack team, check out our investment newsletters.
Fool contributor Seth Jayson loves writing his own SQL queries, but screening for budget stocks is fun, too. He has no stake in any firm mentioned above. View his Fool profile here. The Motley Fool is investors writing for investors.
