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7 Key Traits Required For Stock Selection.

In Chapter 14 of Benjamin Graham's The Intelligent Investor, he focuses on the 7 items for defensive stock selection.

In the preface, this chapter is highlighted by Warren Buffett as one of the keynote chapters, and therefore the reader should pay special attention to the advice that Graham offers.

For those who are unfamiliar with Benjamin Graham he was a former fund manager, professor, and is considered the father of value investing.  Value investing is a strategy where stocks are purchased at less than their intrinsic value.  Intrinsic value in layman's terms is the amount the company is worth (Assets - Liabilities = Worth).

By the way, the equation above is not the actual method for finding intrinsic value, it is just a gross oversimplification of what it means.  I would also like to note that intrinsic value is different than the stock price.  The stock price is what the market is valuing the company at, but it may not reflect its intrinsic value.

For example: 

Let's say Bob's Burger has revenue of $1,000,000 for the year.  However, it has a net loss of $500,000.  However, because the market is big on burgers right now, Bob's burger is selling at $50 a share, and there are 1,000,000 shares outstanding, thus the market value is 50 * 1,000,000 = $50,000,000.

However, it's intrinsic value (gross simplification again) is -$500,000, because it lost money.  Therein lies the difference between the two metrics.

**This is a good article on the many aspects of tabulating intrinsic value Calculating Intrinsic Value.

Graham states that a company should ideally be able to fit these 7 criteria in order to be worth investing for the defensive investor.

1) Adequate size - The company should be relatively large, and its size should be determined by its annual sales.  An industrial company should have at least $100,000,000 in annual sales, and a public utility should have at least $50,000,000 in total assets.

In the commentary of the chapter, it is noted that a company should have a total market value greater than $2,000,000,000.

The idea behind this is to weed out smaller companies, so that your pool focuses on large companies.

2) Sufficiently Strong Financial Condition - The current assets of a company should be at least twice the current liabilities.  In addition, a company's long term debt should not exceed its net current assets.

The thinking behind this is, is that if the company goes through a difficult year or a bear market it has the staying power to withstand it without selling off parts of its business.

3) Earning Stability - The company must show earnings over the past ten years

4) Dividend Record - The company must show uninterrupted dividend payments for at least the past 20 years.

5) Earning Growth - The company must show a minimum increase of at least 1/3 in per share earning in the past 10 years, using 3 year averages for beginning and tail ends.

For example:

Lets stay Luke's Lights historic 3 year average is $9 per share.  Then the average of the most recent 3 years should be at least 1/3 higher, therefore at least $12 per share.  This is a bit more than a 4% increase per year over a ten year period, assuming you start at $9 and end around $12.

6) Moderate P/E Ratio - To calculate the Price to Earnings Ratio take the current price and divide it by the average earnings of the last 3 years.  The current price should not be more than 15 times the average earnings of the past three years.

One way to look at P/E Ratio (Price to Earnings) is that it is illustrates how much it costs for the company to earn a $1.

So for example:

Let's say that Gorilla Glue costs $10 per share, and lets assume its average earnings over the past 3 years was $2 per share.  There for its P/E ratio is 10/2 = $5 per share.  Or, in other words for ever $5 invested in the company, it earns a $1.

*Note: Most P/E ratios are calculated using the last 12 months earnings.  Graham recommends the past 3 years to include a larger sample size and therefore a more reliable set of data.

For more information on Price to Earning Ratios, Investopedia has a great piece on it: P/E Ratios

7) Moderate Ratio of Price to Assets - The company's current price not more than 1.5 times the book value last reported.

The book value of a company is the Total Assets - Total Liabilities.  However, Graham recommends that you should also subtract Goodwill & Intangible Assets since these are just accounting tools rather than actual hard assets.  So the true formula should be:

(Total Assets - Goodwill - Intangible Assets - Total Liabilities)/Shares Outstanding

What this means is that this will be a more conservative method of tabulating the Book Value of a company.

Let's take Facebook for example:

According to Finance.Yahoo, its current Book Value Per Share is $21.50

If we use Graham's formula then we need to look at the Balance Sheet.  Below are the Assets.  Keep in mind that all values are in the thousands, so all values have to be multiplied by 1,000 unless otherwise stated.
So to tabulate the first part we do Total Assets - Goodwill - Intangible Assets, therefore
68,714,000 - 18,126,000 - 2,360,000 = 48,228,000

We then subtract 48,228,000 (which represent its true total assets) from Total Liabilities.

48,228,000 - 6,526,000 = 41,702,000 which represents its book value.

We then take 41,702,000 * 1,000 and divide it by the Shares Outstanding which is 2.36 Billion.
[Remember above, I stated that on the balance sheet all values are written in the thousands, so therefore you have to multiple 41,702,000 by 1,000 to get its real value]

So 41,702,000,000/ 2,360,000,000  = 17.67

So FaceBook's book value per share is $17.67 per share using Graham's method.  As to $21.50 per share as it is listed on Finance.Yahoo.  Thus illustrating the company is worth less than what it is reporting. 

This is why you need to remove items such as Goodwill and Intangible Assets when tabulating the book value, for more on this, read my post on The Essays of Warren Buffett.

So, going back to characteristic 7 - Moderate Ratio of Price to Assets.  It is recommended not to pay over 1.5 times the book value.  So the Price to Book ratio is: 

the current price per share/book value per share

As of today - July 11, 2017 the price of FaceBook is listed above.  So the ratio is:

153.65 / 17.67 = 8.696

So since 8.696 > 1.5, it is recommended to not buy FaceBook as of today because it is expensive at the moment.

I hope you enjoyed reading this post as much as I enjoyed writing it.  I hope that you take away the knowledge and skill set to be a defensive investor who puts in the research and reading to determine if a stock is a good pick.  If you have any questions, comments, or feedback please write in the comments section.  Also please subscribe for more future posts!!

Thanks for reading!!


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