Stepan Co. - A Defensive Graham Study

Summary

• Warren Buffett writes that he's been exclusively following Benjamin Graham's Value Investing framework for 57 years.
• Graham recommended five investing strategies - Blue Chips, Defensive, Enterprising, NCAV, and Special Situations.
• SCL clears nearly all of Graham's criteria for Defensive investment, his most stringent set of criteria.

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Stepan Company (SCL) is a manufacturer of specialty and intermediate chemicals used in a broad range of industries. The company was founded in 1932 by Alfred C. Stepan Jr.

Headquartered in Northfield, Illinois, Stepan manufactures basic and intermediate chemicals, including surfactants, specialty products, germicidal and fabric softening quaternaries, phthalic anhydride (P.A.), polyurethane polyols and special ingredients for the food, supplement and pharmaceutical markets.

Benjamin Graham is known as the "father of value investing". Warren Buffett writes that he's been exclusively following Benjamin Graham's Value Investing framework for 57 years.

Defensive Investment Criteria

Previously, we discussed Graham's five investment strategies in How To Build A Complete Benjamin Graham Portfolio.

Graham's criteria for Defensive investment - the most stringent of his strategies - are as follows:

1. Not less than $100 million of annual sales.
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 ten 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 ten years using three-year averages at the beginning and end.
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.

The above rules are from Chapter 14: Stock Selection for the Defensive Investor of Graham's magnum opus, The Intelligent Investor.

Criterion #1 works out to $500 million today, based on the difference in CPI/Inflation from when the book was written in 1971.

The Intrinsic Value for a Defensive stock can be calculated from the quantitative criteria (#6 and #7) for Defensive investment given above, and is popularly known as the Graham Number.

Let's see how SCL's numbers stack up against the above requirements.

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Financial Condition

Given below are SCL's Sales and Balance Sheet figures.

• Annual Sales: $1,925.00 Million
• Current Assets: $789.00 Million
• Intangibles: $44.00 Million
• Goodwill: $25.00 Million
• Total Assets: $1,471.00 Million
• Current Liabilities: $320.00 Million
• Long Term Debt: $268.00 Million
• Total Liabilities: $731.00 Million
• Shares Outstanding: 23.40 Million

Note: Graham analyses are done exclusively with annual data.

Per Share Values

Given below are SCL's BVPS and EPS values used to calculate its Defensive Price (Graham №).

• Book Value Per Share: $32.86
• Tangible Book Value Per Share: $30.93
• Earnings Per Share (EPS)): $3.92
• EPS - 1 Year Ago: $3.73
• EPS - 2 Years Ago: $3.32
• EPS - 3 Years Ago: $2.49
• EPS - 4 Years Ago: $3.18
• EPS - 5 Years Ago: $3.49
• EPS - 6 Years Ago: $3.21
• EPS - 7 Years Ago: $2.95
• EPS - 8 Years Ago: $2.92
• EPS - 9 Years Ago: $1.76

Defensive Graham investment requires 10 years of uninterrupted positive earnings.

Graham Ratings

Using the above figures, we get the following Graham Ratings for SCL.

• Sales or Size (100% ⇒ $500 Million): 385.00%
• Current Assets ÷ [2 x Current Liabilities]: 123.28%
• Net Current Assets ÷ Long Term Debt: 175.00%
• Earnings Stability (100% ⇒ 10 Years): 100.00%
• Dividend Record (100% ⇒ 20 Years): 100.00%
• Earnings Growth (100% ⇒ 33% Growth): 132.65%
• Graham Number(%): 58.70%
• NCAV or Net-Net(%): 2.80%
• Equity ÷ Debt (for Utilities and Financials): 101.23%

A Defensive Graham grade requires that all ratings - except the last three - be 100% or more.

From the above ratings, we see that SCL:

• Exceeds the Sales/Size criteria by nearly 4 times, even adjusted for inflation.
• Exceeds the Current Ratio requirement by 23%.
• Has nearly twice the required Net Current Assets to Long Term Debt ratio.
• Has uninterrupted positive earnings in each of the past ten years.
• Has uninterrupted dividend payments for the past 20 years (data not included here).
• Exceeds the Earnings Growth requirement by 32%.

Intrinsic Value

Using the above data, we also get the above price calculations for SCL:

• Defensive Price (Graham №): $52.00
• Enterprising Price (Serenity №): $38.14
• NCAV Price (Net Current Asset Value or Net-Net): $2.48
• Graham Grade: Defensive
• Intrinsic Value: $52.00
• Previous Close: $88.59
• Intrinsic Value(%): 58.70%

SCL clears Graham's qualitative criteria for the Defensive investment grade. Therefore, its Intrinsic Value is equivalent to its Defensive Price (Graham №).

Incidentally, the Intrinsic Value(%) too is the same as the Graham Number(%) for all for Defensive grade stocks.

However, SCL's Intrinsic Value(%) evaluates to less than 100% - 58.70% - because its Previous Close is higher than its Intrinsic Value.

But we're not done yet.

Current Bond Yields

Graham's Intrinsic Value formulas actually allow for P/E ratios of 30 - or more - today based on current bond yields. This means that we need to multiply the Graham Number above by 1.41 to arrive at the true Intrinsic Value for SCL.

Final Intrinsic Value = $52.00 x 1.41 = $73.50

Another way to put this would be that considering today's bond yields, Defensive grade stocks only need an Intrinsic Value(%) of 70% to be considered true Graham stocks.

This is because 1.41^-1 = 0.7 or 70%.

At 58.70%, SCL falls short of that requirement by a bit. But then, as explained in the Graham Ratings section, SCL far exceeds the qualitative criteria that Graham required.

It may be helpful to remember that Graham himself wrote:

It would not be illogical for an investor to buy such an issue at a small discount from its indicated or appraisal value, on the theory that it is only a small distance away from a primary classification and that it may acquire such a rating unqualifiedly in the not too distant future.
- Chapter 7, The Intelligent Investor.