In his later years, Benjamin Graham tried to simplify the process of analyzing investments by coming up with some simple investment checklists to help investors uncover those stocks that looked to offer value with ease.
One such checklist was the enterprising investor screen, a less strict approach than his other highly defensive deeply discounted securities' screens as it is designed to help investors find unpopular companies, unique situations and "bargain" issues rather than well-financed and profitable companies trading at a highly discounted valuation.
The eight criteria of the enterprising investor screen are as follows:
- The stock must be trading at a price-earnings (P/E) of less than 10.
- The company must have a current ratio (current total assets divided by total current liabilities) of greater than 1.5. This is designed to screen for companies with strong balance sheets.
- Long-term debt < 1.1 x working capital. Once again, a test of balance sheet strength.
- Profitability: the company must have reported positive earnings per share for the past five years or more.
- Has the company paid a dividend in the past five years?
- Are earnings per share greater than they were five years ago?
- Is the company trading at a price to tangible book ratio of less than 1.2?
- Does the company have its primary listing in the U.S.?
Hunting for Graham stocks
One stock that meets all of these criteria is Kelly Services Inc. (KELYA, Financial). With a market capitalization of $816 million Kelly is not a small business, but it appears to be small enough to fly under the radar of most investors.
For 2016 the company reported earnings per share of $3.2, giving a trailing 12-month price-earnings (P/E) of 6.6. (Going forward Wall Street analysts have penciled in earnings per share of $1.70 for 2017 and $1.80 for 2018 indicating that the shares trade at a 2018 P/E of 11.8, slightly above Graham's requirement).
Based on last year's figures, the company sports a current ratio of 1.55 and with a net cash balance of just under $30 million at the end of 2016, Kelly also meets criteria No. 3 easily.
On to earnings growth. Over the past five years, Kelly has been able to grow earnings per share at a compound annual rate of 12.2% for the year to the end of 2016. A dividend per share of 20 cents was paid annually between 2012 and 2015 with the payout rising to 25 cents for 2016. Based on Wall Street estimates for 2017 earnings, Kelly's earnings per share will be around 28% higher in 2017.
On to the last two points. With a book value of around $28.5 per share at the end of 2016, the company is trading at a price-book (P/B) value of 0.76 and a price to tangible book value of 0.83. Over the past six years, book value has grown at a compound annual rate of 8.4%.
Finally, the company has its primary listing in the U.S.
Calculating valuation
It looks as if Kelly Services meets all of the criteria on Benjamin Graham's Enterprising Investor list, but what's the margin of safety here?
How much could the shares be worth, and is the margin of safety broad enough to justify an addition to your portfolio?
As well as his various investment checklists, Graham also puts together several models for valuing shares, one of which was the Graham Rule of Thumb, a number designed to replace a DCF calculation.
Originally, the valuation model was V = EPS * (8.5 + 2g) where V is the intrinsic value, EPS is the trailing 12-month EPS, 8.5 is the P/E ratio of a no-growth stock and g being the growth rate for the next seven to 10 years, but this was later adapted to incorporate the different impact of interest rates environments by adding a divisor in the form of the current yield on 20-year AAA corporate bonds.
Assuming current regular earnings per share of $1.80, a medium term earnings per share growth rate of 6.1% per annum (half of the five-year average), growth multiplier of 1.5x and a yield on 20-year AAA corporate bonds of 5.2%, this formula suggests Kelly's shares should be worth $26.8. This result indicates that the shares are 25.8% undervalued at current levels.
Disclosure: The author owns no share mentioned.
