Tutorial - Benjamin Graham and Serenity Stocks

Quick Reference

Contents

Introduction
Quantitative Measures - EPS and BVPS
Qualitative Categories - Defensive, Enterprising and NCAV
The Graham Number
Net Current Asset Value (NCAV)
Finding Graham Stocks Today - Classic Graham Screening
Finding Graham Stocks Today - Advanced Graham Screening
A Sample Graham Analysis - Universal Corporation
Other Graham Strategies - Index Funds and Special Situations
To Conclude - The Margin of Safety

Appendix I - The Benjamin Graham Formula
Appendix II - Graham's Notes on Selling
Appendix III - General Graham Principles

Introduction

Benjamin Graham - once known as The Dean of Wall Street - was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

Warren Buffett describes Graham's book - The Intelligent Investor - as "by far the best book about investing ever written" (in its preface).

In this tutorial, we'll look at how Graham's investment framework can be applied - as faithfully as possible - to today's stock markets using modern technology.

Quantitative Measures - EPS and BVPS

The first numbers to look at when evaluating a stock are its Earnings Per Share (EPS) and Book Value Per Share (BVPS). They tell us how much we're getting for our money.

Earnings Per Share

EPS tells us how much profit the company makes per share.

EPS combined with price gives us a rough idea of the rate of return we can expect on our investment. EPS and Price are usually mentioned together as the P/E ratio, or Price-to-Earnings ratio.

Book Value Per Share

BVPS is the theoretical liquidation value of the stock. That is, if the company were to close tomorrow, BVPS tells us how much we would be paid per share after all the company's assets are sold at their depreciated prices, and all liabilities are paid.

However, most companies also include Goodwill and other Intangibles - which have no resale value - in their balance sheets. It's important to use only tangible assets when calculating liquidation values.

Qualitative Categories - Defensive, Enterprising and NCAV

When buying something, we also need to look at how good it is, and not just how much we're getting.

Graham recommended three different measurable categories of stocks, with different quantitative (EPS and BVPS) and qualitative (Growth and Stability) requirements for each category. Just as with buying anything else, higher quality stocks are costlier; i.e., we pay more for them per dollar of EPS and BVPS.

First Category - Defensive

The safest (but costliest) category of stocks recommended by Graham were for Defensive investors. The criteria that Graham specified for identifying them are as follows:

Summarized from Chapter 14 of The Intelligent Investor - Stock Selection for the Defensive Investor:
1. Not less than $100 million of annual sales.
[This works out to $500 million today based on the difference in CPI/Inflation from 1973]
2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past 10 years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past 10 years.
6. Current price should not be more than 15 times average earnings of the past three years.
7. Current price should not be more than 1-1⁄2 times the book value.
As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

Graham's recommended price for Defensive quality stocks can be calculated from criteria #6 and #7. This price is popularly known as the Graham Number.

Note: Graham Numbers on Serenity are calculated using the average EPS of the past three years, as Graham required.

The Graham Number is designed to quantitatively assess any stock, regardless of sector or industry. For example, public utility companies that are typically low on Earnings will need higher asset figures to be acceptable. Similarly, service sector companies that are typically low on assets will need higher Earnings figures to be acceptable.

Graham recommended a minimum portfolio size of 10 for Defensive quality stocks; or in other words, not more than 10% of one's portfolio per Defensive quality stock.

Assessment Results on Serenity

If the stock meets the qualitative criteria (#1 to #5) for Defensive investment above:

Qualitative Result = Defensive
Intrinsic Value = Defensive Price (Graham Number)
Quantitative Result = Intrinsic Value ÷ Previous Close (capped at a maximum of 100%)

Second Category - Enterprising

For Enterprising investors who are looking for greater profits - and are willing to put in more effort into the maintenance of their portfolio - Graham then recommended the following criteria for identifying Enterprising quality stocks:

Summarized from Chapter 15 of The Intelligent Investor - Stock Selection for the Enterprising Investor:
[For issues selling at P/E multipliers under 10]
1-A. Current assets at least 1 1⁄2 times current liabilities.
1-B. Debt not more than 110% of net current assets.
2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year's earnings more than those of 1966.
[Corresponds to the earnings of 5 years ago]
5. Price: Less than 120% net tangible assets.

Thus, the price limit for a stock meeting Enterprising quality requirements is the lower of 120% net tangible assets, or 10 times current earnings. We can combine the two - as Graham did for the Defensive Price - to yield a quantitative price calculation similar to the Graham Number. We'll call this the Serenity Number.

As with the Graham Number, the Serenity Number too applies to any stock - regardless of sector or industry - because it's a combination of both Assets and Earnings. A lower value in one will have to be compensated for by a higher value in the other.

Serenity's recommendation is for a minimum portfolio size of 20 for Enterprising quality stocks; or in other words, not more than 5% of one's portfolio per Enterprising quality stock.

Assessment Results on Serenity

If the stock meets the qualitative criteria (#1 to #4) for Enterprising investment above:

Qualitative Result = Enterprising
Intrinsic Value = Enterprising Price (Serenity Number)
Quantitative Result = Intrinsic Value ÷ Previous Close (capped at a maximum of 100%)

Third Category - Net Current Asset Value / NCAV

These stocks are also known as Net-Nets or cigar-butt stocks today. Graham did recommend these stocks for Enterprising investors, but with additional qualitative checks and diversification requirements.

Summarized from Chapter 15 of The Intelligent Investor - Stock Selection for the Enterprising Investor:
Bargain Issues, or Net-Current-Asset Stocks
the results of buying 30 issues at a price less than their net-current-asset value
It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone—after deducting all prior claims, and counting as zero the fixed and other assets— the results should be quite satisfactory.
If we eliminated those which had reported net losses in the last 12-month period we would be still left with enough issues to make up a diversified list.

These criteria give us stocks selling for less than their cash worth alone, and with positive earnings in the last year.

The positive EPS requirement is the qualitative check for NCAV stocks; and is very important. There's not much point buying a stock for its current assets (cash equivalents) alone, if the company's losing money.

Since NCAV stocks undergo the least qualitative tests of all of Graham's categories, they also require the most diversification. Graham recommended a portfolio size of 30 for NCAV stocks; or in other words, not more than 3.3% of one's portfolio per NCAV stock.

Assessment Results on Serenity

If the stock has a positive EPS and a positive Net Current Asset Value:

Qualitative Result = NCAV
Intrinsic Value = NCAV Price (Net Current Asset Value)
Quantitative Result = Intrinsic Value ÷ Previous Close (capped at a maximum of 100%)

Finding Graham Stocks Today - Classic Graham Screening

Today's data mining software makes it relatively easy to find stocks that clear even such elaborate criteria.

Serenity's algorithms apply the above 17-point framework to 5000+ U.S. stocks. The Classic Graham Screener lists all stocks meeting up to 90% of Graham's quantitative criteria. Shown below is a list of such stocks that meet all of Graham's qualitative Defensive criteria.

Similar searches can also be done for Graham's Enterprising and NCAV criteria.

We can thus build a 90% compliant Graham stock portfolio today, using the Classic Graham Screener alone.

GN÷PC

The Classic Graham Screener can also be used to screen stocks by their Graham Numbers (GN÷PC is short for Graham Number ÷ Previous Close).

For example, shown below is the list of stocks selling at a fifth of their Graham Numbers, or less:

Note: The sliders on numerical filters can be adjusted with the mouse or with the keyboard arrow keys. Filter values can also be typed in.

Finding Graham Stocks Today - Advanced Graham Screening

The Advanced Graham Screener allows us to:

  • Fine-tune Graham's rules with more customizable filter combinations.
  • View and compare more data per stock, and more stocks per page.
  • View stocks with Quantitative Results > 90%, and stocks analyzed by other users.

For example, here is a partial list of stocks that completely meet Graham's NCAV criteria, and also have $250 Million in Sales and 5 years of uninterrupted positive Earnings. Only two stocks are shown here due to limited screen space.

Note: The Quick Reference section on Defensive Graham Ratings may help in understanding this section of the tutorial better.

The Graham Number is 137% of the Serenity Number (for a stock with a Reported BVPS with no intangibles).



Essentially, for a given EPS and BVPS, we pay 137% more for a Defensive quality stock since it is of higher quality than an Enterprising quality stock. Thus, the criteria for Enterprising quality stocks can be approximately replicated on the Advanced Graham Screener using the values - CA÷2CL: 75%, NCA÷LTD: 90%, EPS Stability: 50%, Div Record: 5% and GN÷PC: 137%.

Note: This is assuming that the Reported BVPS has no intangibles. If it does, GN÷PC would need to be higher than 137%. Enterprising quality stocks also need to have an EPS higher than they did 5 years ago.

Shown below is a list of stocks that completely meet Graham's NCAV criteria, and additionally clear all the above criteria.

Note: GN÷PC shows 135 instead of 137 because the slider for that particular filter moves in steps of 5.

Each one of these stocks already clears Graham's NCAV criteria completely, in addition to clearing most of the criteria for Enterprising investors. The Advanced Graham Screener can thus be used to select stocks of both higher and lower compliance with Graham's specifications.

Lastly, the Advanced Graham Screener can also be used to compare all Graham ratings - and other data - for any set of stocks of your choice, as shown below.

Note 1: This comparison can be done on the Classic Graham Screener as well, but with fewer fields for comparison across stocks.
Note 2: See how one might adjust Benjamin Graham's price calculations today.
Note 3: The Equity÷Debt filter allows for the screening of Public-Utilities and Financial Enterprises without using the Current Asset criteria.

A Sample Graham Analysis - Universal Corporation

To understand how a full Graham analysis works, let's take the example of Universal Corporation.

In the Financial Condition tab for UVV on Serenity, we see the Sales and Balance Sheet figures that were used in the Graham analysis:

This data is used to calculate Graham ratings such as CA÷2CL, NCA÷LTD etc., and the NCAV price.

Any differences in Tangible BVPS and Reported BVPS affect both the Enterprising Price, as well as the Quantitative Result for Enterprising quality stocks. So every stock on Serenity has both the Reported BVPS and Tangible BVPS displayed on it in the Per Share Values tab as shown below. Only the Tangible BVPS is used for evaluating Enterprising quality stocks.

Combining the above data with UVV's dividend history, we get the following Defensive Graham Ratings for UVV:

Note: Stocks that don't clear Graham's Defensive, Enterprising and NCAV rules are not necessarily bad investments. They may fall under Graham's Special Situations category. The Defensive Graham Ratings tab gives a good overall picture of a stock's Margin of Safety.

Lastly, shown below is the Final Graham Assessment tab for UVV which gives a summary of the Graham analysis.

We see that UVV has different Defensive, Enterprising and NCAV prices. We also see that the qualitative result for UVV is Defensive and thus, the Defensive Price (Graham Number) is also its Intrinsic Value. Finally, we see that UVV has a Quantitative Result of 100% since its Intrinsic Value is more than its previous closing price.

Note: Quantitative Results on Serenity are capped at a maximum of 100% to avoid differentiating between stocks that clear Graham's quantitative criteria to different degrees.

Thus, not only do we get a full 17-point Graham analysis for UVV, we also see all the data used for the analysis. So once a potential list of stocks for investment is shortlisted using Serenity's screeners, the figures used for analysis can (and should) be verified against the annual reports of the individual companies before investment.

Other Graham Strategies

Index Funds

Graham taught that the easiest strategy - for any investor who did not have the time for stock research and portfolio maintenance - was to proportionally invest in stocks that comprise one of the Indices. This is something that can be done a lot more easily today, by investing in an Index Fund.

Quoted from Chapter 14 of The Intelligent Investor - Stock Selection for the Defensive Investor:
In the first he acquires a true cross-section sample of the leading issues, which will include both some favored growth companies, whose shares sell at especially high multipliers, and also less popular and less expensive enterprises. This could be done, most simply perhaps, by buying the same amounts of all thirty of the issues in the Dow-Jones Industrial Average (DJIA).

So it should be safe to say that Graham's first recommended strategy today would be to invest in a good Index Fund that follows a reputed index such as the DJIA or the S&P 500.

Note: This strategy includes expensive growth stocks (as described above), and is an especially clear refutation of the myth that Graham's framework was restricted to cheap stocks and cigar-butts; a misconception created by misinterpretations of Graham's NCAV strategy.

Special Situations or "Workouts"

Graham wrote that, in theory, Special Situations was a part of the program of operations of an Enterprising investor. But he classified them as a business altogether different from regular investing.

As the name indicates, these are special strategies that follow no specific rules or calculations. Some of the operations Graham classified under this category are:

  • Acquisitions of smaller firms by larger ones.
  • Arbitrage operations.
  • The breakup of public-utility holding companies pursuant to legislation, and
  • Issues that are involved in any sort of complicated legal proceedings and with prices beaten down to unduly low levels due to the ensuing prejudice.

Being able to identify and take advantage of a Special Situation requires extensive experience with Graham's other strategies. Graham himself wrote:

The exploitation of special situations is a technical branch of investment which requires a somewhat unusual mentality and equipment. Probably only a small percentage of our enterprising investors are likely to engage in it

And elsewhere, he noted about Workout or Arbitrage opportunities:

This has become more than ever a field for professionals, with the requisite experience and judgment...

Special Situations are therefore not amenable to large-scale automated analysis such as Serenity's, and need to be studied on a case by case basis. But any investment of this kind would still need to be within a Margin of Safety, and meet Graham's definition of an investment operation:

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

To Conclude - The Margin of Safety

In The Intelligent Investor, Graham says "to distill the secret of sound investment into three words, we venture the motto - Margin of Safety". While the popular interpretation of the margin today is to buy stocks with low P/E and P/B ratios, a true Graham Margin of Safety is both qualitative and quantitative as described above.

Graham taught that, over the long run, an investor's returns depend on the amount of intelligent effort he is willing to bring to his investments; and that increased risk - contrary to popular belief - actually reduces returns.

Warren Buffett once gave a speech at Columbia Business School explaining how Graham's record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham's principles are everlasting. The speech is now known as The Superinvestors of Graham-and-Doddsville.

Buffett concluded the speech saying:

"Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper."


Appendix I - The Benjamin Graham Formula

Benjamin Graham gave several warnings with the below formula, and only used it to demonstrate that growth rate projections were almost never reliable.

V = EPS x (8.5 + 2g), or
Intrinsic Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

But due to an omission in recent editions of The Intelligent Investor, this formula is often used to evaluate stocks today instead of Graham's actual (and more thorough) methods.

Understanding The Benjamin Graham Formula Correctly has more details.


Appendix II - Graham's Notes on Selling

Graham is said to have made a reference to "sell at 50-100% gains or after 2-3 years" in one of his interviews. But the interview is not verifiable in print, and claims to be from an indirect source.

Serenity recommends following Graham's printed material.

Given below are Graham's notes on selling, from his books and printed lectures:

"buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies."
- The Investor and Market Fluctuations, The Intelligent Investor

"even defensive portfolios should be changed from time to time, especially if the securities purchased have an apparently excessive advance and can be replaced by issues much more reasonably priced"
- Stock Selection for the Defensive Investor, The Intelligent Investor

"the only principle of timing that has ever worked well consistently is to buy common stocks at such times as they are cheap by analysis, and to sell them at such times as they are dear, or at least no longer cheap, by analysis."
- Lecture Number Ten, The Rediscovered Benjamin Graham Lectures

And here is an important addendum:

"The intelligent investor must carefully evaluate the costs of trading and taxes before attempting to take advantage of any price discrepancy—and should never count on being able to sell for the exact price currently quoted in the market."
- Things to Consider About Per-Share Earnings, The Intelligent Investor

There are numerous such references and the underlying principle in all of them is consistent. The investor is to run the numbers for his portfolio occasionally - once a year or so - and readjust the portfolio as required. Stocks that no longer clear the Graham framework - either due to price appreciation or value deterioration - are to be sold. They may be replaced with new stocks that clear the Graham framework.

If the Graham figures had been run rigorously earlier, replacement due to value deterioration should be unlikely. Graham's Margin of Safety requirements are very thorough. That's why it's so difficult to find stocks that meet them in the first place.


Appendix III - General Graham Principles

Given below is a summarized list of general Do's and Don'ts based on Graham's writings and The Intelligent Investor.

Graham Do’s Graham Don’ts
Always invest with a quantifiable Margin of Safety. Don't speculate. Avoid risky investments.
Invest in Index funds if you don’t have the time for stock research. Most actively managed funds don't keep up with the Indices.
Invest for the long term, for periods of at least a year or more. Don't try to get rich quick, from frequent trading or from tips.
Apply intelligent effort. Spend time and energy on research. Minimize trading activity and expenses. Ignore trends and forecasts.
Grow your savings and plan for dividend income. Don't try to earn an income from frequent trading.
Use discount brokers, who work on low fixed rates and high volumes. Full service brokers charge in percentages and encourage speculation.
Manage your own money, with a strategy suited to your situation. Letting others manage your money may involve Moral Hazard[1].
Pricing - plan on entering and exiting positions at the right price. Not timing - Never enter at the wrong price, intending to exit at the right time.
Buy stocks like groceries - look for good quality, and value for money. Not like perfume - fashionable names are expensive, and unprofitable.
Be logical, patient and courageous. If your research is thorough, you will be proven right. Don't be emotional. Don’t sell on panic or buy on greed. Ignore the market and its fluctuations[2].
Be an independent thinker. Success depends on correct data and reasoning, not consensus. Don't follow the herd. Successful strategies and stocks are also usually unpopular.
Have a focussed strategy. Use adequate diversification to mitigate risk. Don't compromise on quality of research with excessive diversification.
Keep it simple. Use basic arithmetic well. Don't be influenced, or intimidated, by financial jargon.

[1]Since stock markets are considered unpredictable and since financial professionals work with your money, they can take risks with it, lose it, and still get paid. This ability to take risks with no downside is called Moral Hazard.
[2]Graham introduced the famous analogy of a Mr. Market who came to the investor every day with a different price. Sometimes the prices were reasonable. Most of the time, they weren't. Buffett simplified it further by describing Mr. Market as “manic-depressive".