“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” -Benjamin Graham.
- Benjamin Graham was a legendary value investor who trained Warren Buffett.
- Selecting stocks based on valuation could be smart in a high interest rate environment.
- Top stocks that can be bought in value portfolios now.
Nowadays, Warren Buffett is considered the be-all-end-all of value investors, but Benjamin Graham was the value investors’ icon before Buffett. In fact, it was studying under Graham that was most influential to Buffett’s investing style.
The lessons taught by Graham in his book “The Intelligent Investor” have inspired many value investors beyond Buffett, including Real Money Pro’s Jonathan Heller. Recently, Heller explained how he modified Graham’s approach to account for inflation in “This 73-Year-Old Investment Strategy Is Still Working Today.”
Specifically, here are eight factors Heller thinks investors should use to find stocks worthy of a Benjamin Graham-style portfolio of value stocks, followed by my comments where appropriate.
No. 1: “Adequate size. A company must have at least $500 million in sales on a trailing 12-month basis. (Graham used a $100 million minimum and at least $50 million in total assets).”
While it's tempting to chase the smallest stocks in the hope of big returns, tiny companies are easily manipulated. They usually trade very few shares daily, so it doesn’t take much selling to cause them to drop ferociously. Also, tiny companies can be heavily-reliant on a limited number of customers or products, making them overly susceptible to competition.
As a result, the idea of ‘striking it rich’ with penny stocks is usually a myth. Investing in micro-cap stocks can wipe an investor out, so focus on slightly larger companies that are less likely to be the target of fraudsters' shenanigans or the loss of a big customer.
No. 2: “Strong financial condition. A company must have a current ratio (current assets divided by current liabilities) of at least 2.0. It also must have less long-term debt than working capital.”
The ability to pay the piper when due is a crucial tenet of value investing.
You can easily calculate the current ratio using the current assets and liabilities listed on a company’s balance sheet. The higher the ratio, the better a company can pay its short-term obligations, decreasing the likelihood of bankruptcy. Working capital is simply current assets minus current liabilities. If there are more easily-accessible assets than long-term obligations, the risk of bankruptcy is further reduced.
Tip: Many websites calculate the current ratio for you.
No. 3: “Earnings stability. A business must have had positive earnings for the past seven years. (Graham used a 10-year minimum.)
Earnings are where the rubber meets the road, particularly when the Federal Reserve is increasing interest rates, devaluating future cash flows. Highly unprofitable companies rely heavily on future growth, which becomes less of a certainty in tough times.
Unprofitable stocks are less attractive during high-interest rate periods because dollars can be invested in safer Treasury bonds instead. For this reason, earnings consistency is particularly important because it provides some insulation against interest rate-related devaluation.
No. 4: “Dividend record. The company must have paid a dividend for the past seven years. (Graham required 20 years.).”
Benjamin Graham wrote, “The true investor... will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies.”
Warren Buffett’s success stems from his favoring stocks with a history of paying investors dividends. He wrote, “We all hope for capital gains, but the only thing we can really count on is the dividend.”
Dividends provide valuable cash that can be used to buy more shares, allowing investors to dollar-cost average their holdings, or to pay for retirement expenses. Importantly, dividends can substantially increase returns. According to long-time researcher Sam Stovall of CFRA Research, dividends have been responsible for one-third of the S&P 500’s returns since 1945.
Tip: To find out how long a company has been paying dividends, visit the company’s investor relations website. You can also find lists of companies with long dividend-paying track records online, including dividend aristocrats, companies that have paid dividends for at least 25 years
No 5: “Earnings growth. Earnings must have expanded by at least 3% compounded annually over the past seven years. (Graham mandated a one-third gain in earnings per share over the latest 10 years.).”
Often, corporate earnings decline because a company is losing market share to competitors or is being disrupted by new technologies. To minimize the risk of investing hard-earned money in stocks with shrinking moats, concentrate only on companies that grow profit over time.
No. 6: “Moderate price-to-earnings (P/E) ratio. A stock must have had a 15 or lower average P/E over the past three years.”
Share price divided by earnings per share (net profit divided by outstanding shares), or P/E, is a key valuation metric. Pay too much for a company's earnings, and you could wind up with a money-losing investment. Especially if interest rates increase, causing a devaluation of future cash flows.
No. 7: "Moderate ratio of price to assets. The price-to-earnings ratio times the price-to-book value ratio must be less than 22.5."
Benjamin Graham used a variation of this calculation to determine the most he would be willing to pay to own shares in a particular company. In theory, a company’s book value is the amount of money a company would generate if its assets are sold, so value investors use it to ensure they’re not overpaying.
For example, let’s say a company’s EPS is $2, and its book value is $15 per share. Graham would calculate the square root of 22.5 times $2 times $15, resulting in a maximum price he would be willing to pay of $25.98.
(Square root of 22.5*$2*15)
Tip: Set up a spreadsheet with this formula to quickly determine if a stock is trading above or below levels Graham would have been interested in buying.
"No 8: No utilities or retailers"
Benjamin Graham used different criteria for evaluating utilities, so Heller doesn't use this methodology to consider them. He's also less interested in retail stocks, given the "value trap" nature of the basket.
The Smart Play
Benjamin Graham was a legendary value investor who produced roughly a 20% annualized return between 1936 to 1956, substantially better than the market’s 12.2% return. His ability to identify bargains worth buying has inspired a generation of value investors, resulting in The Intelligent Investor remaining one of the most popular investment books on the planet.
Although few were interested in value investing during the post-COVID, easy-money rally, it has recaptured investors' attention this year. Higher interest rates have forced a lower revaluation for growth stocks, but dividend-paying value stocks have performed much better.
For example, using the aforementioned screening process in Spring, Heller identified a slate of companies that have since outperformed the market index. He writes: “When I ran that screen in May, 10 names made the cut. [They’re] up an average of 4.5% (not including dividends) -- ahead of the S&P 500 (down 2.8%) and Russell 2000 (up 1.8%).”
What stocks pass the screen now? Heller reran the screen last week, and 15 stocks made the grade, including a handful of new ideas: Huntsman (HUN) , Korn Ferry (KFY) , Worthington Industries (WOR) , Standard Motor Products (SMP) , and Insteel Industries (IIIN) .
Investors can consider if those stocks meet their investment criteria. Or if they wish to avoid single stock risk, a value-oriented exchange-traded fund may make sense.
For example, Vanguard’s High Dividend Yield ETF (VYM) includes over 440 dividend-friendly, large-cap stocks comprising the FTSE® High Dividend Yield Index. Through December 23, the VYM was down less than 1% year to date, while the S&P 500 had fallen nearly 20%. Over the past decade, the VYM’s compounded annual return is about 12%, a healthy return that could make owning it worth considering.