Defensive Investor Questions

All of the questions below pertain to building a Defensive Investor stock portfolio:

1) Do you use intangible or tangible book value for calculating the graham number? Also do you use 1 year or 3 years of past earnings?
2) I am using 1.71% for current bond yield based on vanguard AA corporate 10 year bond yield, so that makes the threshold 50% I believe compared to 70%. Does that sound right to you?
3) What is wrong with LEN current assets, I believe it clears when I calculate it in my excel but not in serenity stocks for defensive grade?
4) How do you factor in the requirement for pe over 25 for the past 7 years?
5) Why isn't the stability index used when calculating earnings stability?
6) why do you use 15 instead of 13.3 in the formula?
7) what do you think about the fact the BG says there will be hundreds of securities to choose from that meet this criteria for defensive but in today's world (in USA) there are only 5 industrials and 26 financials (a bit more if we use 50% instead of 70% but not more than 30 industrials when current interest rate is taken into account)?
8) It says 26 financials and utilities clear but I don’t see any utilities and financials above 70% , only the 5 industrials?
9) Where does it say that the financials need to have the last 2 criteria exceeding for financials? I see in the book where the requirement exists for utilities but I don’t see that requirement for financials.
10) Does a good defensive stock just need to be over 70% (or 50% if we adjust per question 2) or should there be an additional margin of safety (eg value should be 80%), so that you make your gain when it "reverts to the mean" or intrinsic value at 70%?

Stocks Discussed: 
LEN

Dear dmaren,

Thank you for your forum post!

Please refer to the Quick Reference for additional information regarding the responses below.

1) Do you use intangible or tangible book value for calculating the graham number? Also do you use 1 year or 3 years of past earnings?

Graham clearly specifies "book value" for Defensive grade stocks and "net tangible assets" for Enterprising grade stocks. Serenity therefore uses Book Value Per Share (BVPS) for the Defensive Price (Graham №) and Tangible Book Value Per Share (TBVPS) for the Enterprising Price (Serenity №). Serenity also uses the average earnings of the past three years for Defensive Price (Graham №), for the same reason.

2) I am using 1.71% for current bond yield based on vanguard AA corporate 10 year bond yield, so that makes the threshold 50% I believe compared to 70%. Does that sound right to you?

That is correct. A bond yield of 1.71% should translate to an Intrinsic Value of 50% on Serenity.

3) What is wrong with LEN current assets, I believe it clears when I calculate it in my excel but not in serenity stocks for defensive grade?

Serenity gets all data for its automated analyses from its data provider — Finnhub — and there appears to be no current balance sheet data available for Lennar Corp (LEN). Since Graham's framework is designed to err on the side of caution, Serenity does the same and leaves stocks ungraded when any required data is unavailable.

4) How do you factor in the requirement for pe over 25 for the past 7 years?

Kindly give a reference as to where such a requirement is described — "pe over 25 for the past 7 years".

5) Why isn't the stability index used when calculating earnings stability?

In keeping with the principle of focus, Serenity does a complete 17-Rule Benjamin Graham analysis and nothing more. For further discussion, kindly give a reference as to how the Stability Index can be used to calculate the Earnings Stability for individual stocks.

6) why do you use 15 instead of 13.3 in the formula?

Graham clearly specifies "15 times average earnings" for Defensive grade stocks, and Serenity therefore uses a multiple of 15 when calculating the Defensive Price (Graham №).

7) what do you think about the fact the BG says there will be hundreds of securities to choose from that meet this criteria for defensive but in today's world (in USA) there are only 5 industrials and 26 financials (a bit more if we use 50% instead of 70% but not more than 30 industrials when current interest rate is taken into account)?

Hypothesizing about macroeconomic factors that could have caused such a shift is difficult. A general analysis on the Advanced Graham Screener appears to indicate that while a lot of stocks have the required earnings and dividend stability even today, they fall short in the balance sheet ratings. This may indicate a less conservative management style today than was prevalent in the past. However, Graham himself noted that Utilities were more likely to clear the criteria for Defensive grade stocks.

8) It says 26 financials and utilities clear but I don’t see any utilities and financials above 70% , only the 5 industrials?

The filter values for Utilities and Financials are slightly different.

9) Where does it say that the financials need to have the last 2 criteria exceeding for financials? I see in the book where the requirement exists for utilities but I don’t see that requirement for financials.

Please see the link in the previous response above.

10) Does a good defensive stock just need to be over 70% (or 50% if we adjust per question 2) or should there be an additional margin of safety (eg value should be 80%), so that you make your gain when it "reverts to the mean" or intrinsic value at 70%?

This is a question that is often asked in the context of NCAV (Net-Net) stocks. Graham's stock selection framework appears to be designed with the required Margin of Safety built into it, and he does not specify the need for an additional margin anywhere. He gives separate instructions on selling as well.

Thank you again for your forum post!

Dear Serenity,

Thank you for the detailed an very helpful responses. Please find my follow up responses below:

1) Based on my reading of the Intelligent Investor, it is my understanding that Graham intends tangible book value (tangible asset value) to be used for the Defensive Investor criterion rather than including goodwill and intangibles. Here are the references that lead me to this conclusion. I am curious to hear your thoughts on the below? Pg 199 ch 8 :

“A conclusion of practical importance to the conservative investor... concentrate on issues selling at a reasonably close approximation to their tangible-asset value... The premium over book value that may be involved can be considered as a kind of extra fee paid... The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets."

[I would interpret this as suggesting that asset value criterion in ch 14 would in fact be “tangible-asset value” and that Graham uses “asset value” or “book value” as short for and interchangeably for “tangible asset value”.

Zweig would seem to agree with the fact that he uses all terms to refer to “tangible asset value” in his footnote on pg 198:

“Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth... Divide by the fully diluted number of shares outstanding to arrive at book value per share.”

How would you interpret it?

2) Perfect, no further questions.
3) Perfect, no further questions.

4) On page 115 of ch 5 this is stated: “The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last twelve-month period.”

5) The stability index is referenced in ch 14 in Table 14-3 and then defined on pg 333 per the foot note in the table (ch 13): “Stability: This we measure by the maximum decline in per share earnings in any one of the past ten years, as against the average of the three preceding years. No decline translates into 100% stability…”

6) Will do further research and post a follow up to this question if required.
7) Will do further research and post a follow up to this question if required.

8) Could you give a ticker for one example of a financial and one example of a utility that currently meets the Defensive Grade?

9) Will do further research and post a follow up to this question if required.
10) Will do further research and post a follow up to this question if required.

Dear dmaren,

Thank you for your detailed and thoughtful comment!

Please see the responses below.

1) Based on my reading of the Intelligent Investor, it is my understanding that Graham intends tangible book value (tangible asset value) to be used for the Defensive Investor criterion...

While it is true that Graham often uses the terms Book Value and Net Tangible Assets interchangeably, here is what he has written himself on the subject.

"In some cases good-will has actually been acquired at a definite cost by purchase from former owners of the business, and it is then feasible to show the good-will at cost in the same manner as other assets."

Benjamin Graham and Spencer Barrett Meredith, Chapter 8: Intangible Assets, The Interpretation of Financial Statements (1937).

"If the company were actually liquidated the value of the assets would most probably be much less than their book value as shown on the balance sheet... book value really measures, therefore, not what the stockholders could get out of their business (its liquidating value), but rather what they have put into the business"

Benjamin Graham and Spencer Barrett Meredith, Chapter 20: Book Value or Equity, The Interpretation of Financial Statements (1937).

The subject is therefore more complex than it appears at first and considerable thought was given to this issue.

Serenity therefore simply applies Graham's instructions in the Stock Selection chapters to the letter, without interpretation. Serenity uses Book Value where Graham says Book Value, and Net Tangible Assets where he says Net Tangible Assets.

4) On page 115 of ch 5 this is stated: “The investor should impose some limit... 25 times such average earnings, and not more than 20 times those of the last twelve-month period.”

While a valid point, it appears Graham was simply giving a preliminary foundation here for the actual framework he would be laying out later. Again, Serenity simply applies Graham's instructions in the Stock Selection chapters to the letter.

5) The stability index is referenced in ch 14 in Table 14-3 and then defined on pg 333...

Another valid point. Graham does discuss various metrics in various chapter and sections. But again, Serenity only applies Graham's metrics as defined in the Stock Selection chapters, including the one for Earnings Stability.

8) Could you give a ticker for one example of a financial and one example of a utility that currently meets the Defensive Grade?

If you were to click on the button for screening Utilities and Financials in the Quick Reference or the Utilities and Financials post, you should see a list of eligible stocks including those from the Energy, Utility and Financial sectors.

Specific stocks cannot be discussed here for obvious reasons, but can be discussed offline.

Thank you again for your detailed and thoughtful comment!

Graham Resources