Benjamin Graham was the father of fundamental security analysis. His value-based stock-picking method has strong points—and weak points.
Benjamin Graham believes defensive investors should stick with large, prominent companies that are unpopular. In his book, The Intelligent Investor, Mr. Graham writes: “The large companies have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.”
We agree with Mr. Graham. The fact is, if a small company disappoints the market, investors will often neglect these companies even if their profits recover. In fact, that’s partly why our Key stocks include mostly larger companies. Then again, neglected small companies can offer good value.
Graham required strong balance sheets
Mr. Graham also likes high current ratios (current assets divided by current liabilities). This too is sensible. After all, a company with lots of current assets can pay its bills as they fall due and side-step insolvency. Another thing to remember is that plenty of current assets can protect companies against adverse developments. The failure of clients, for example, can hurt the value of accounts receivable. As another example, a firm may have to take a loss to clear out inventory. Both the above reduce the size of current assets, so insisting on stocks with high current ratios is smart.
Mr. Graham also wants current assets to exceed long-term debt. Excessive? Perhaps, but that’s because the corporate graveyard is filled with companies that took on too much debt. This includes Canwest Global Communications, Laidlaw and Lehman Brothers, among others.
Buying companies with a history of profits is also a good idea. Our reservation here is that Mr. Graham often includes one-time items.
Emphasizing dividend payers is also sensible. However, here, too, we have some reservations.
Mr. Graham thinks investors should buy companies that offer some growth. Otherwise “The typical company would show retrogression, at least in terms of profit per dollar of invested capital. There is no reason for the defensive investor to include such companies.” But at the same time, Mr. Graham thinks most growth stocks are over-priced. We think he strikes the right balance on the matter of growth.
Emphasizing reasonable price-to-earnings ratios, of course, helps side-step the problem of over-paying for a company. So does insisting on a reasonable price-to-book ratio. Mr. Graham’s idea of ensuring that the price-to-earnings ratio times the price-to-book ratio remain at or below 22.5 also adds a reasonable degree of flexibility in stock picking.
Overall, we greatly respect Mr. Graham’s approach. But we also have some criticisms.
It’s like criticizing God
To criticize Mr. Graham is a little like criticizing God. It’s just not done. But since we live in a different country and time than Mr. Graham, here are a few issues worth nitpicking about. One is that Mr. Graham’s tests rely on historical data. Yet the market looks forward.
We agree that forward-looking data like earnings-per-share estimates often err. In fact, that’s why we seldom predict how much companies will earn many years from now. However, estimates for the current year are less apt to backfire. A company of yours may have a reasonable price-to-earnings ratio based on this year’s expected earnings. Trouble is, Mr. Graham’s approach would exclude the company.
Mr. Graham said little about rising dividends. Yet this puts the odds of success in your favour. Including a test for dividend growth similar to the one he uses for earnings growth would likely improve your results.
Also, Mr. Graham’s requirement of 20 years of continuous dividends is excessive. Especially in Canada. Even big, prominent companies such as US Key stock Amazon.com, which has never paid a dividend, fall short. Five or 10 years might be more appropriate.
Finally, Mr. Graham is critical of companies that report earnings excluding one-time items. Yet often this gives a better idea of a company’s underlying and ongoing earnings.
This is an edited version of an article that was originally published for subscribers in the October 20, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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