Benjamin Graham Defensive Investor Screen: How does it work?

In Brief

A demanding intrinsic value-based screen designed for less experienced investors which focuses on “important” companies with long histories of profitable operations and strong financial condition. 

Background

Benjamin Graham was the mentor of Warren Buffet and is considered the first proponent of value investing, along with David Dodd through various editions of their famous book Security Analysis. In 1947, Benjamin Graham published “The Intelligent Investor,” a book that outlined in detail his investment philosophy, and which is now considered an investment classic. In the book, Graham describes how his approach would be applied by two different types of investors—those that are “defensive” (i.e. those investors unable to devote much time to the process or inexperienced with investing) and those that are “enterprising” (with greater market experience and more time for portfolio management). Graham felt defensive investors should confine their holdings to the shares of large, prominent, and conservatively financed companies with long histories of profitable operations. By this, he meant a firm of substantial size and with a leading position in its respective industry.

Additionally, Graham sought companies with:

• Strong financial position (based on the current ratio & debt to working capital).
• 20 years of uninterrupted dividends
• No negative earnings in the last 10 years & a 10-year annual earnings growth rate of at least 3%
• A reasonable price-earnings ratio &  a moderately low ratio of price to assets

Graham summarized his own philosophy by stating that intelligent investing consists of analyzing potential purchases according to sound business principles. This includes making your own decisions, ensuring that you are not risking a substantial portion of your original investment, and sticking to your own judgments without regard to market opinion.

"You are neither right nor wrong because the crowd disagrees with you... You are right because your data and reasoning are right".

Calculation / Definition

Here are seven criteria that he suggests for defensive investors looking for a quality stocks. Some of his rules are extremely strict, meaning that very few stocks pass his criteria. This had lead some to relax the criteria, although that does perhaps defeat the point of the exercise. At the time of writing, Graham viewed utilities as particularly attractive for defensive investors, hence some criteria include adjustments specifically for utilities.

1. Size: Sales > $400 million ($100m originally, but adjusted for inflation since the time of Graham’s writing). Smaller companies are generally subject to wider fluctuations in earnings. For industrial companies, Graham used annual sales as a proxy for company size but, for utilities, he used $50m of assets instead ($250m inflation adjusted). 
2. Strong Financial Condition, defined as i) Current Ratio  > 2.0 (as a test of short-term liquidity, Graham specified that, for industrial companies, a company's easily accessible assets were at least double their immediate debts - no current ratio requirement was specified for the utility sector) and  ii) Long Term debt < Working Capital. Long term debt should not exceed the working capital or net current assets and, for public utilities who tend to have very high debts because of their infrastructure, the debt should not exceed twice the stock equity (at book value, not market value).
3. Earnings Stability: EPS > 0 for the last 10 Years on the basis that companies that have maintained at least some level of earnings are more likely to be stable going forward.
4. Dividend track record over a 20 year period – this is not an easy thing to screen for, admittedly and few companies pass this test as nowadays, companies are more inclined to use excess cash to buy back their shares.
5. Earnings growth >= 3% on average over last 10 years. Graham wanted to see defensive companies grow their EPS by at least one third over the last 10 years, implying this minimum compound growth rate.
6. Price Earnings Ratio < 15, using an average of EPS for the last three years.This is to account for special charges and to overcome the impact of cyclical business.
7. Price to Book < 1.5. Graham recommended that the current price should not be more than 1.5x the book value last reported. However, he noted that a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, he suggested that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

Does it Work?

AAII data shows that its Defensive Investor Screen has enjoyed an 8.2% return since inception vs. 2.4% for the S&P 500. You can see further specific criteria backtests on the Old School Value blog. 

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Geek Stuff

Graham’s goal in establishing the cut-off of a 15x P/E was apparently to establish a portfolio that was priced reasonably on average compared to the yield available to the AA bond yield. At the time he wrote the book, investment-grade bonds were yielding 7.5% (the inverse of this yield 13.3 determines the overall portfolio price-earnings ratio target and therefore the maxium of 15x). As bond yields go up (or down), an investor would require that the price-earnings ratio be lower (or higher) to consider purchase of stocks.  At present, US yields are 4.25%, so a maximum PE ratio closer to 20x  might be more appropriate (1/5%).

See here for the Enteprising Investor Screen. 

Watch Out For 

Graham suggested that there should be adequate though not excessive diversification. This might mean a minimum of ten and a maximum of about thirty stocks. Stock holdings should be reviewed at least annually, he said, paying attention to dividend returns and the operating results of the company, and ignoring share price fluctuations. Graham felt that as long as the earnings power of the holdings remained satisfactory, the investor should stick with the stock and ignore any market movements, particularly on the downside. On the other hand, investors should take advantage of market fluctuations on the upside, when a stock becomes overvalued or fairly valued; at these times, investors should sell and replace their holdings.

From the Source

Graham first described his method for defensive investors in The Intelligent Investor. An updated edition of The Intelligent Investor, with new commentary from veteran columnist Jason Zweig, was published in 2003. You may also want to check out Securities Analysis but, at 700 pages long, it's not for the faint-hearted. 

Other Sources

• Wikipedia on Benjamin Graham
• AAII on Defensive Investor Screen
• Benjamin Graham: Three Timeles Principles
• Corporate Bond Yields on Yahoo
• Intelligent Investor Stock Selection for the Defensive Investor
• Seven Tests of Defensive Stock Selection