AAII Stock Screens April 2006 21 Value investing has proven V V itself over time to be a highly successful investment ap- proach. And while success has many fathers, Benjamin Graham is certainly one of them. In this case, father really does know best. Graham’s approach focuses on determining the “in- trinsic” value of a stock, which takes into consideration the firm’s earnings, tangible assets, dividends, financial strength and stability. He believes investors should buy stocks whose prices are close to their intrinsic value, and preferably those that are priced lower than their intrinsic value. AAII developed several screens based on Graham’s in- vesting philosophy. Two of the screens, Graham Defensive Investor (Non-Utility) and Graham Enterprising Investor, were the top-performing value strategies in 2005, and both have respectable long-term records. This article briefly outlines Graham’s investing philoso- phy, and then describes the performance and characteristics of the two top-performing AAII screens that are based on Graham’s value approach. Graham’s Philosophy In 1947, Graham published “The Intelligent Investor,” a book that outlined in detail his investment philosophy, and which he continued to update periodically. The book 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” and those that are “enterpris- ing.” The defensive, or passive, investor is one who does not have or is not willing to spend a great deal of time analyzing or tracking individual stocks. In contrast, the Enterprising Investor has greater market experience, as well as additional time to devote to portfolio management. The Defensive Investor For the Defensive Investor, Graham recommends pur- chasing shares of “important” companies that have histories of long-term profitability and strong financial positions. To Graham, important companies are those of substantial size, based on annual sales, with a leading position in a leading industry. Additionally, Graham seeks companies with: • Strong financial positions, as indicated by the current ratio (current assets divided by current liabilities) and the ratio of long-term debt to working capital (current assets minus current liabilities); • 10 years of positive earnings; • 20 years of uninterrupted dividends; • A 10-year annual earnings growth rate of at least 3%; • A reasonable price-earnings ratio (Graham modifies this ratio by averaging earnings over several years to overcome business cycles and the impact of special charges); • A moderately low ratio of price to assets (calculated by multiplying the price-earnings ratio by the price-to-book value ratio). Enterprising Investors Graham encourages Enterprising Investors to search for G raham’s Long-Term Winning Approach for Enterprising & Defensive Investors By Cara Scatizzi
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April 2006 21
Value investing has proven Value investing has proven Vitself over time to be a highly successful investment ap-proach. And while success has many fathers, Benjamin Graham is certainly one of them. In this case, father really does know best.
Graham’s approach focuses on determining the “in-trinsic” value of a stock, which takes into consideration the fi rm’s earnings, tangible assets, dividends, fi nancial strength and stability. He believes investors should buy stocks whose prices are close to their intrinsic value, and preferably those that are priced lower than their intrinsic value.
AAII developed several screens based on Graham’s in-vesting philosophy. Two of the screens, Graham Defensive Investor (Non-Utility) and Graham Enterprising Investor, were the top-performing value strategies in 2005, and both have respectable long-term records.
This article briefl y outlines Graham’s investing philoso-phy, and then describes the performance and characteristics of the two top-performing AAII screens that are based on Graham’s value approach.
Graham’s Philosophy
In 1947, Graham published “The Intelligent Investor,” a book that outlined in detail his investment philosophy, and which he continued to update periodically. The book 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” and those that are “enterpris-ing.” The defensive, or passive, investor is one who does not have or is not willing to spend a great deal of time analyzing or tracking individual stocks. In contrast, the Enterprising Investor has greater market experience, as well as additional time to
devote to portfolio management.
The Defensive InvestorFor the Defensive Investor, Graham recommends pur-
chasing shares of “important” companies that have histories of long-term profi tability and strong fi nancial positions. To Graham, important companies are those of substantial size, based on annual sales, with a leading position in a leading industry. Additionally, Graham seeks companies with:
• Strong fi nancial positions, as indicated by the current ratio (current assets divided by current liabilities) and the ratio of long-term debt to working capital (current assets minus current liabilities);
• 10 years of positive earnings;• 20 years of uninterrupted dividends;• A 10-year annual earnings growth rate of at least 3%; • A reasonable price-earnings ratio (Graham modifi es this
ratio by averaging earnings over several years to overcome business cycles and the impact of special charges);
• A moderately low ratio of price to assets (calculated by multiplying the price-earnings ratio by the price-to-book value ratio).
Enterprising InvestorsGraham encourages Enterprising Investors to search for
Graham’s Long-Term
Winning Approach for
Enterprising & Defensive Investors
By Cara Scatizzi
AAII Journal22
AAII Stock Screens
• Current earnings higher than earnings fi ve years ago;
• A low price-to-book ratio. Graham also suggests a mini-
mum of 10 holdings, but prefers a larger group of 30 securities.
AAII’s Graham Screens
AAII developed two separate screens that attempt to closely repli-cate Graham’s principles, one for the Defensive Investor and one for the Enterprising Investor. The screens were developed using Stock Inves-tor Pro, AAII’s fundamental stock screening and research database.
These two screens were the top-performing value screens for 2005.
A complete list of the screening criteria for the two strategies can be found at the end of this article. Stock Investor Pro includes Graham’s Stock Investor Pro includes Graham’s Stock Investor ProDefensive (Non-Utility)* and Enter-prising Investor screens (along with a Defensive Investor (Utility) screen not discussed in this article).
promising investments among fi rms outside of the “important” compa-nies. He suggests looking among: large companies unpopular, indicated by a low price-earnings ratio (P/E); smaller companies in a top industry; or, top fi rms in an unimportant in-dustry. However, he advises against small, undervalued companies, be-lieving the company may not be able to sustain itself through an unstable or adverse market.
Additional criteria for Enterpris-ing Investors are:
• A price-earnings ratio in the bot-tom 10% of all stocks;
• Financial strength based on the current ratio and ratio of long-term debt to working capital;
• Positive earnings for the past fi ve years;
• Dividend paying;
Table 1. Portfolio Characteristics for Graham Screens
Graham All Defensive Graham Exchange- Investor Enterprising ListedPortfolio Characteristics (Median) (Non-Utility) Investor StocksPrice-earnings ratio (X) 9.1 3.6 20.4Price-to-book-value ratio (X) 1.43 0.95 2.29PE to EPS estimated growth (X) 0.95 0.40 1.40EPS 5-yr. historical growth rate (%) 22.7 20.8 10.2EPS 3-5 yr. estimated growth rate (%) 11.6 11.2 14.5Dividend yield (%) 1.4 1.8 0.0Current ratio (X) 2.5 2.1 2.1LT debt to working capital (%) 38.9 26.5 17.5Market cap. ($ million) 2,708.5 17,621.7 457.6Relative strength vs. S&P (%) –18 12 0 Monthly Observations Average no. of passing stocks 17 5 Highest no. of passing stocks 35 15 Lowest no. of passing stocks 1 0 Monthly turnover (%) 21.2 35.4
*Within AAII’s Stock Investor Pro, the Defensive Non-Utility Graham screen is labeled Graham (Defensive-Industrial), the Enterprising screen is labeled Graham (Enterprising), and the Defensive Utility screen is labeled Graham (Defensive-Utility).
April 2006 23
Performance
Figure 1 shows the performance Figure 1 shows the performance Figure 1 shows the performance of the Graham Defensive (Non-Utility) of the Graham Defensive (Non-Utility) of the Graham Defensive (Non-Utility) screen and the Graham Enterprising screen and the Graham Enterprising screen and the Graham Enterprising Investor screen since 1998. Investor screen since 1998. Investor screen since 1998.
Both screens got off to a slow start, Both screens got off to a slow start, Both screens got off to a slow start, lagging the S&P 500 until 2000 with the lagging the S&P 500 until 2000 with the lagging the S&P 500 until 2000 with the Enterprising screen posting negative Enterprising screen posting negative Enterprising screen posting negative returns for 1998 and 1999. However, the returns for 1998 and 1999. However, the returns for 1998 and 1999. However, the Graham approaches are value-oriented, Graham approaches are value-oriented, Graham approaches are value-oriented, so the early market-lagging performance so the early market-lagging performance so the early market-lagging performance is not a surprise. The late 1990s marked is not a surprise. The late 1990s marked is not a surprise. The late 1990s marked the tail-end of a bull market, an environ-the tail-end of a bull market, an environ-the tail-end of a bull market, an environ-ment in which the focus was on growth ment in which the focus was on growth ment in which the focus was on growth (particularly Internet stocks during this (particularly Internet stocks during this (particularly Internet stocks during this tech bubble), and value approaches in general tended to lag the market.
The market environment changed dramatically when the technology sector bubble burst, causing value to come into favor once again. In 2001, both screens saw their highest yearly return—61.5% for the Defensive screen and 55.3% for the Enterprising screen—in contrast to the S&P 500, which lost 13.0%.
Cumulatively, each screen has outperformed the S&P’s small-, mid-, and large-cap indexes since 1998. The Defensive Investor screen has gained 345.0% from January 1998 through January 31, 2006, while the Enterprising Investor screen logged a higher return of 415.8% over the same period.
Profi le of Passing Companies
Table 1 lists the characteristics of the stocks passing the Graham De-fensive Investor (Non-Utility) screen and the Graham Enterprising Investor screen as of February 10, 2006.
Table 2 lists the passing stocks, ranked in ascending order by price-earn-ings ratio. The number of passing stocks for each screen is small—six companies
passed the Defensive Investor (Non-Utility) screen, while only one passed the Enterprising Investor screen.
Portfolio TurnoverOn average, the Defensive (Non-
Utility) screen has 17 stocks passing each month, with an average monthly turnover rate of 21.2%. The Enterpris-ing screen has, on average, only fi ve stocks passing each month, with a 35.4%
Table 2. Companies Passing the Graham Screens PE LT Debt/ 52- Using EPS Current Working Wk
Company (Exch: Ticker) PE Avg EPS PB Grth Div Ratio Capital Mkt Rel Graham Defensive Ratio 3 Yrs Ratio 7 Yr Yield Q1 Q1 Cap StrgthInvestor (Non-Utility) (X) (X) (X) (%) (%) (X) (%) ($Mil) (%) DescriptionAshland Inc. (N: ASH) 2.4 5.7 1.3 39.5 1.7 2.7 3.6 4,598.0 –3.0 paving & spec chemsPOSCO (ADR) (N: PKX) 3.6 8.0 1.0 30.5 1.8 2.1 26.5 17,621.7 12.0 mfgs steelSchnitzer Steel (M: SCHN) 6.6 9.5 1.5 51.0 0.2 2.6 37.1 945.4 –18.0 auto parts & steelLiz Claiborne, Inc. (N: LIZ) 11.5 13.6 1.8 11.8 0.7 2.3 46.9 3,643.1 –24.0 brand apparelBriggs & Stratton (N: BGG) 12.9 15.2 2.0 9.2 2.6 2.4 59.1 1,773.8 –19.0 gas enginesSteel Tech (M: STTX) 14.0 11.9 1.3 19.3 1.1 3.4 40.6 345.3 –18.0 steel processor
Exchange Key: M= NASDAQ National or NASDAQ Small Cap Market, N= New York Stock Exchange.Source AAII’s Stock Investor Pro/Reuters Research, Inc. Data as of 2/10/2006.Stock Investor Pro/Reuters Research, Inc. Data as of 2/10/2006.Stock Investor Pro
Determining the P/E Cut-Off forGraham’s Defensive Investor
In “The Intelligent Investor,” Graham’s goal for the Defensive Investor was to establish a portfolio whose earnings yield [earnings divided by price (E/P), or the inverse of the price-earnings ratio] was at least comparable to that of 10-year AA bonds. Therefore, he required the price-earnings ratio to be no higher than the inverse of investment-grade bond yields. Additionally, Graham modifi es the price-earnings ratio by using the aver-age earnings over the last three years to account for special charges and to overcome cyclical business impacts.
At the time Graham wrote his book, investment-grade bonds were yielding 7.5%; the inverse of that yield (1 divided by 0.075) determined the overall portfolio price-earnings ratio objective of 13.3.
But current long-term high-grade corporate bond yields differ from those prevailing when Graham set his price-earnings objective, and therefore the cut-off needs to be adjusted. When bond yields increase, Graham’s formula requires a lower price-earnings ratio. Conversely, lower bond yields mean that an investor could accept a higher price-earnings cut-off, which makes more stocks available for consideration.
The current AA 10-year bond yield is 5.1%; the inverse of the current bond yield (1 divided by 0.051) is 20.
AAII Journal24
AAII Stock Screens
average monthly turnover rate. It is not a surprise that both Gra-
ham screens have low turnover rates compared to all of the strategies AAII follows, since value strategies in general tend to have lower turnover.
Price-Earnings RatiosBecause Graham focuses on fi nding
stocks selling at a signifi cant discount, the price-earnings ratio is an important characteristic for both Defensive and Enterprising Investors.
Graham’s Defensive Investor screen uses a modifi ed version of the price-earnings ratio, which averages earnings over several years to account for special charges and to overcome the impact of cyclical business. Graham’s price-earnings ratio requirement for the Defensive Investor seeks to produce a stock portfolio that is reasonably priced compared to the current yield of AA bonds; in today’s interest rate environ-ment, the Defensive Investor screen requires a modifi ed price-earnings ratio of 20 or less [for more on how Graham determines the price-earnings ratio for the Defensive Investor, see the box on page 23].
Graham set a more restrictive price-earnings ratio level for Enterprising Investors, who should look for stocks with a price-earnings ratio in the lowest 10% of all stocks. As of February 10, 2006, that means a price-earnings ratio of 9.5 or lower.
Due to the value orientation of Graham’s screens, it is not surprising to see in Table 1 that the median price-earn-ings ratio of the passing companies (9.1 for Defensive and 3.6 for Enterprising) is much lower than the typical exchange-traded stock (20.4).
Table 2 shows that Steel Tech-nologies, Inc. is the “richest” passing company, with a price-earnings ratio of 14.0.
Price-to-Book RatiosGraham also looks for securities
with low price-to-book ratios, generally below 1.5. However, he feels that a low price-earnings ratio can justify a slightly higher price-to-book ratio.
Graham recommends that Defen-sive Investors multiply the price-earn-ings ratio by the price-to-book ratio and seek stocks where that value does not exceed 30 (an acceptable modifi ed price-earnings ratio of 20 times a 1.5 price-to-book ratio).
Graham recommends that Enter-prising Investors should look for stocks with a price per share that is less than or equal to 1.2 times its tangible book assets (price-to-book ratio), a more restrictive criteria.
Not surprisingly, given these restric-tions, Table 1 indicates that the median price-to-book ratios for both the De-fensive screen (1.43) and Enterprising screen (0.95) are less than the typical exchange-traded stock (2.29).
Earnings StabilityEarnings stability is another impor-
tant principle for Graham. Both screens require positive historical earnings and strong earnings growth rates.
The Graham Defensive (Non-Util-ity) screen requires seven years of posi-tive earnings and a seven-year annualized earnings per share growth rate of 3% or higher. [Although Graham suggests investors examine a 10-year earnings history, the AAII screen is constrained by the Stock Investor Pro database earn-Stock Investor Pro database earn-Stock Investor Proings history, which is limited to seven years.]
The Graham Enterprising screen is less restrictive, requiring only positive earnings over the last fi ve years; it also requires that current fi scal-year earnings be higher than earnings fi ve years ago.
Both screens have a higher historical earnings growth rate—22.7% for Defen-sive and 20.8% for Enterprising—than the average exchange-traded stock, with a 10.2% median growth rate.
Among the passing companies listed in Table 2, Briggs & Stratton Corpora-tion has the lowest seven-year annualized earnings growth rate of 9.2%, while Schnitzer Steel Industries has an impres-sive 51.0% annualized growth rate.
Graham’s focus on strong earnings growth and low price-earnings ratios is refl ected in the lower median PEG ratios (price-earnings ratio divided by
the estimated earnings per share growth rate for fi ve years).
DividendsIn addition to earnings growth,
Graham is a fi rm believer in dividends. Both screens look for companies that pay dividends.
The Graham Defensive (Non-Utility) screen requires that a company has paid a dividend over the trailing 12 months and for each of the last seven years. [Although Graham suggests inves-tors examine a 20-year dividend history, the AAII screen is constrained by the Stock Investor Pro database dividend his-Stock Investor Pro database dividend his-Stock Investor Protory, which is limited to seven years.]
As with other criteria for the Enter-prising Investor, the dividend criteria for this screen is more relaxed, only calling for a dividend payment over the trailing 12-month period.
Both screens also require that a company intends to pay a dividend over the next four fi scal quarters.
Dividend yields for the current list of passing companies range between 0.2%, for Schnitzer Steel, and 2.6%, for Briggs & Stratton Corporation.
Strong Financial PositionGraham believes that a company
with a strong fi nancial position can continue to prosper—or at least not fail—during a downturn in the market. A fi rm’s current ratio (current assets divided by current liabilities) shows the liquidity of a company’s assets; the higher the ratio, the stronger the fi nancial position of the fi rm.
The Graham Defensive Investor screen looks for stocks with a current ra-tio of at least 2.0, while the Enterprising Investors screen considers stocks with a slightly lower current ratio of 1.5.
Table 2 shows that Steel Technolo-gies Inc. currently has the highest current ratio of 3.4.
In addition to liquidity, Graham looks to long-term debt and its relation-ship to working capital (current assets minus current liabilities) as another measure of fi nancial stability.
For both screens, Graham believes long-term debt should not exceed net
April 2006 25
current assets or working capital. The current assets or working capital. The current assets or working capital. The AAII screens have quantifi ed this by AAII screens have quantifi ed this by AAII screens have quantifi ed this by using a long-term debt to working using a long-term debt to working using a long-term debt to working capital ratio, which, Graham specifi es, capital ratio, which, Graham specifi es, capital ratio, which, Graham specifi es, should always be positive and less than should always be positive and less than should always be positive and less than or equal to 100%.or equal to 100%.or equal to 100%.
Table 2 indicates that Ashland Inc. Table 2 indicates that Ashland Inc. Table 2 indicates that Ashland Inc. has by far the lowest ratio of long-term has by far the lowest ratio of long-term has by far the lowest ratio of long-term debt to working capital, at 3.6%.debt to working capital, at 3.6%.debt to working capital, at 3.6%.
Market CapitalizationMost of the stocks currently passing Most of the stocks currently passing Most of the stocks currently passing
these two screens have median market these two screens have median market these two screens have median market capitalizations much larger than the capitalizations much larger than the capitalizations much larger than the typical exchange-listed stock ($457.6 typical exchange-listed stock ($457.6 typical exchange-listed stock ($457.6 million). This is to be expected, since million). This is to be expected, since million). This is to be expected, since Graham favors larger companies, and the Defensive Investor (Non-Utility) screen requires annual sales of at least $400 million. (The annual sales require-ment has been raised from Graham’s original recommendation of $100 mil-lion due to infl ation.)
The median market cap of a
stock currently passing the Defensive Investor (Non-Utility) screen is $2.7 billion while the one stock passing the Enterprising screen has a market capitalization of $17.6 billion. Three of the six companies passing the Defensive screen, including the one company also passing the Enterprising screen, are in the steel business. Most likely this is due to the cyclical nature of the steel industry and a slowing demand for cars and new homes.
Relative StrengthOver the past 52 weeks, the stocks
currently passing the Defensive Investor (Non-Utility) screen have underper-formed the S&P 500 by 18%, while the single stock passing the Enterprising Investor screen has outperformed the market by 12%.
The typical exchange-traded stock has matched the performance of the S&P over the same time period (relative
What It Takes: Graham CriteriaDefensive (Non-Utility):
• Those companies that are part of the utilities sec-tor are excluded
• Sales over the last 12 months are greater than or equal to $400 million
• The current ratio for the last fi scal quarter (Q1) is greater than or equal to 2.0
• The long-term debt to working capital ratio for the last fi scal quarter (Q1) is greater than 0% and less than 100%
• Earnings per share for each of the last seven fi scal years and for the last 12 months are positive
• The seven-year growth rate in earnings per share is greater than 3%
• The company intends to pay a dividend over the next year (indicated dividend greater than zero)
• The company has paid a dividend for each of the last seven fi scal years and over the last 12 months
• A modifi ed price-earnings ratio of 20 or less (see box on page 23)
• The price-earnings ratio multiplied by the price-to-book ratio is less than or equal to 30 (price-earn-ings ratio maximum of 20 times 1.5, which is the maximum price-to-book ratio)
Enterprising: • The price-earnings ratio is among the lowest 10%
of the database (Percent Rank less than or equal to 10)
• The current ratio for the last fi scal quarter (Q1) is greater than or equal to 1.5
• The long-term debt to working capital ratio for the last fi scal quarter (Q1) is greater than 0% and less than 110%
• Earnings per share for each of the last fi ve fi scal years and for the last 12 months have been posi-tive
• The company intends to pay a dividend over the next year (indicated dividend is greater than zero)
• The company has paid a dividend over the last 12 months
• Earnings per share for the last 12 months are greater than the earnings per share from fi ve years ago (Y5)
• Earnings per share for the last fi scal year (Y1) are greater than the earnings per share from fi ve years ago (Y5)
• The price-to-book ratio is less than or equal to 1.2
strength of 0%).
Conclusion
Graham’s investing philosophy focuses on fi nding larger, well-known companies with strong historical growth rates that are selling at a discount. De-spite a slow start in 1998 and 1999, this approach, as embodied in AAII’s Gra-ham Defensive Investor (Non-Utility) and Enterprising Investor screens, has proved to be a winning strategy over the last eight years.
The passing companies of each screen do not represent a list of rec-ommended stocks. As with all types of investing, it is important to perform due diligence to verify the stock’s fi nancial strength and earning potential. It is also essential to decide if the stocks match your investing style and risk tolerance before committing your investment dollars.
Cara Scatizzi is associate fi nancial analyst at AAII.
