In The Intelligent Investor, Benjamin Graham laid out strategies for various categories of investors in markets. One category is the defensive investor who Graham said had two choices.
One choice was to invest broadly across the field in what he called a Dow Jones Industrial Average type of investment and which is today reflected in index funds. In other words, the investor invests in a particular market (Dow Jones Industrial Average companies, S&P top 500 corporations) by buying units in an index fund that replicates that market.
The other option is for the investor to select a portfolio of stocks and bonds on both a qualitative and quantitative basis using specific criteria that he laid out. The portfolio should be diverse (quantitative) and part of the portfolio should be in bonds or equivalent. These are the criteria for quality.
Contents
- 1 The target company should be adequately sized
- 2 The target company should be in a reasonably strong financial condition
- 3 Earnings stability
- 4 The target company should have an uninterrupted payment of dividends
- 5 The target company must have earnings growth
- 6 The price of the shares of the target company must reflect a moderate price to earnings ratio
- 7 The price of the shares in the target company must reflect a moderate price to book value ratio (P/BV)
The target company should be adequately sized
Graham thought that the business should have at least $100 million dollars in annual sales. Bearing in mind the change in value of money since Graham last revised his book, we would think that this figure should be increased to at least $500 million. In an era of larger companies, the figure could perhaps be even higher. We should emphasize here that we are talking in the context of the American business market. Investors in stocks in countries with smaller economies should make their own estimation of what is an adequate size.
Buffett’s perspective on company size
We believe that, as a general rule, Buffett follows this rule in relation to listed companies. If you look at the current holdings of Berkshire Hathaway, very large businesses dominate their holdings. Buffett’s often repeated statement that he would rather buy shares in a great company at a fair price than in a fair company at a great price would seem to confirm this.
The target company should be in a reasonably strong financial condition
Graham’s way of assessing this is to look at the ratio of current assets to current liabilities. This is the current ratio and should be at least 2:1. This makes sense. A business that has difficulties meeting its commitments as they fall due, irrespective of its long term financial viability, is always at risk if something unexpected happens that could trigger a liquidity crisis. In 2008, in the Global Financial Crisis, banks suddenly called in overdraft loans, causing businesses with an insufficient current ratio to scramble for funds. Some investment advisers think that a ratio of 1.5:1 is acceptable for companies with a short operating cycle.
Buffett’s perspective on current ratio
It is clear that Warren Buffett has a similar approach to Graham. He is known to shun companies that have too much debt although his focus is on long term rather than short term debt. Buffett looks at how long it will take a business to pay off its long term debt from current earnings. The longer the period, the higher the risk.
Earnings stability
Graham is somewhat vague on this criterion stating that the company should have some earnings in each of the past ten years. We are assuming by this that Graham is referring to profits and would comment that this could rule out a company that has one bad year through some event that is unlikely to be repeated. Also, the ten year limit is possibly too prescriptive. This principle is a purely defensive one.
Buffett’s perspective on earnings stability
We think that Buffett looks at companies whose earnings grow over a period rather than being satisfied that they had profits in each of the ten years. This means that he does not necessarily rule out a company that has a year of low growth or even negative earnings as a good investment. If the circumstances causing the low growth or negative earnings are not the result of bad management or a flaw in the company’s business plan and is unlikely to be repeated in following years, and the business otherwise qualifies as a worthwhile investment, we think Buffet would see this as an opportunity to increase his holdings rather than reduce them, particularly if the market overreacted. Remember that he says to be fearful when others are greedy and greedy when others are fearful.
The target company should have an uninterrupted payment of dividends
Graham puts the period for the dividend payments by companies at 20 years. Again, this is purely a defensive requirement and, as such, is a valid position. As with earnings however, this does not take into account unusual circumstances in a particular year that is unlikely to be repeated.
Buffett’s perspective on dividends
Berkshire Hathaway has never paid a dividend during Buffett’s tenure and this reflects his belief that profits should be retained by a company to increase the value of the business. It is only when management cannot usefully use earnings to grow the company that they should be returned to shareholders. This is one explanation for the high annualized growth of Berkshire. If it had paid some of its earnings back to shareholders by way of dividend, the increase in value of its shares over the years would have been less.
There are also tax advantages. Dividends bear ordinary rates of tax whereas if shares are sold, the capital gain (represented partly in Berkshire by non-payment of dividends) bears tax generally at a lower rate. And of course while the shares remain unrealized no tax is payable. This can cause a problem for some Berkshire investors as, dividends not being paid, the only way they can derive cash from the shares is to sell them.
The target company must have earnings growth
Graham feels that a company needs to show an increase of at least one third per share over the last ten years, using three year averages. This is not a high hurdle and would only keep up with inflation if there are no excessively high inflation years. The USA Consumer Price Index in December 2002 was 179.88 and in December 2012 was 229.554. This represents a rise of 27.61 per cent, below Graham’s requirement of 33.3 per cent but not by a lot.
Buffett’s perspective on earnings growth
Buffett generally prefers a higher rate of growth but his main concern is that earnings grow rather than remain static or go backwards. That said, one of Berkshire’s main investments and one in which it continues to acquire shares is Wells Fargo with an average growth rate of 2.2 per cent over the last ten years, satisfying neither Buffett nor Graham’s requirements for earnings growth. Of course, the earnings growth of Wells Fargo in common with those of other financial stocks came to a sudden stop during the years of the Global Financial Crisis and actually regressed. This would indicate that Buffett is not seeing a repitition of the events of 2007 and 2008 as likely.
For Graham, the price/earnings (P/E) ratio should be less than 15 based on the last three years average, reflecting the historical ratio of the market.
The P/E ratio is important in making investment decisions because it provides a way of calculating risk. Look at it this way. If you buy shares in a company for $100 and it has a P/E ratio of 20, this means that it is earning for you as a part owner of the company $5 a year (100 divided by 20). If Treasury Bonds have a coupon rate of 5 per cent, why would you buy shares in a business that carries risk in preference to an almost risk free investment - government guaranteed bonds? This is one reason why the prices of shares fall when government interest rates increase and vice versa.
Graham’s figure of 15 is based on his estimate of the long term average rates of government interest rates and his assessment of the risk in buying common stocks.
Buffett’s perspective on P/E
Buffett’s big and successful purchases have generally been at prices with smaller P/E ratios than 15, so we would think he pays a lot of attention to this requirement.
According to Graham, the ratio of price to assets (which he equates to the book value) should not be more than 1.5. However, he suggests that this must be looked at in the light of the P/E ratio. If the P/E ratio is less than 15, then the P/BV ratio can be higher and vice versa. He uses as a rule of thumb a formula that says that the product of the P/E multiplier times the ratio of price to book value should not exceed 22.5. This is sometimes called the Graham ratio. So, using his parameters of 15 for a P/E ratio and 1.5 for a P/BV ratio, we multiply one by the other and get 22.5. If the P/BV ratio was 1.2, then, on the Graham ratio, the stock could have a P/E ratio of 18.75 and still fall within the allowable investment range (1.2 x 18.75=22.5).
Buffett’s perspective on P/BV
To Benjamin Graham, book value generally meant net tangible assets. He did not take into account intangible assets such as intellectual property, mastheads, goodwill and brand name, what Buffett thinks of as economic goodwill. Buffett appears to think differently, placing a lot of emphasis on what he calls intangible good will, an asset that produces profits without the need to invest further capital in it. It is not clear how Buffett values this, but it is certainly a factor in making a decision as to whether a business has a moat, a decided competitive advantage.
