Benjamin Graham is often considered to be “the father of value investing” and an article in Forbes discusses the two models created on his philosophies: the AAII Graham Defensive Investor Non-Utility model, and the AAII Graham Defensive Investor Utility model, which have an average annual gain of 12.7% and 6.7%, respectively.
Graham took the contrarian view that investors could avoid negative influences or misjudgments by focusing on the intrinsic value of a company, as defined by that company’s assets, earnings, dividends, financial health, management quality, and future prospects. Often, a company that fits that bill won’t be a popular one, so investors must maintain their conviction and remain disciplined and patient by swimming against the tide of the market. In his 1947 book The Intelligent Investor, Graham defined two different types of individual investors: “defensive investors” and “aggressive or enterprising investors.” Defensive investors tended to be people who were new to investing or couldn’t devote a lot of time to the process of choosing stocks. Those investors, according to Graham, should stick to companies that are well-known and have a long track record of profitability. Meanwhile, aggressive investors could venture beyond those companies, but their investments should still be reasonably priced.
The article chooses to focus on the screening that defensive investors should use, outlining the set of criteria that Graham composed. While Graham’s approach focused on utilities and industrials, Forbes breaks down the screening for the utilities sector, and then everything else.
Company Size. Investors should consider market capitalization, sales, and total assets when determining company size. Graham favored larger companies because he believed they had more resources to weather adversity.
Robust Financial Health. Graham used various screenings for financial health for different industries. For industrial firms, he looked for a ratio of 2.0 or higher to determine short-term liquidity, but didn’t specify a ratio requirement for utility firms. When looking at long-term debt, it shouldn’t be more than the working capital or net current assets at an industrial firm. Graham also advised looking at the debt-to-equity ratio for utilities.
Earnings Stability. While Graham recommended a firm have at least 10 years of positive earnings, many screening programs that are available today only offer 5 years of data. Forbes recommends looking for at least the last 7 years. Investors can also take into account the Dividend Record; a long stretch of uninterrupted dividends indicates solid earnings and financial strength.
Earnings Growth. Companies should have an increase of at least 1/3 in per-share earnings over the last decade, or a 3% average annual growth rate, according to Graham. Even looking at low multiples would likely reveal if a firm is in trouble. And while companies that aren’t doing well might be worth purchasing at a cheap price, that type of investing doesn’t fall under the purview of the defensive investor.
Moderate Price-Earnings Ratio. Graham typically averaged earnings across several years, requiring that the most recent 3 years showed a price relative to earnings was no higher than 15, with 12 to 13 being the sweet spot. He also wanted to create a portfolio where the stock price is reasonable compared to the bond yield. When yields are lower, investors could consider a higher price-earnings point, and vice versa.
Moderate Ratio of Price to Assets. A proponent of using price-to-book-value to choose stocks, Graham advised defensive investors look for a ratio under 1.5. But if the price-earnings ratio is low, investors could accept a higher price-to-book ratio. In that scenario, investors should multiply the price-earnings ratio by the price-to-book ratio and accept anything under 25.5.
Graham maintained that as long as an investor does careful research, it doesn’t matter if the rest of the market disagrees with them. “You are right because your data and reasoning are right,” he wrote, according to Forbes. “In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”