This is the second in a series of articles on stocks that look attractive according to Benjamin Graham's enterprising investor screen.
The enterprising investor screen is one of several investment checklists Graham compiled toward the end of his life and career. Designed to simplify the investing process, these lists incorporate Graham's lessons throughout the years in regard to finding value stocks that are deeply undervalued.
The enterprising investor screen is not as strict as other value checklists, as it is designed to help investors find unpopular companies rather than "bargain" issues. It is more of a contrarian list rather than a guide for deep-value investors.
In today's environment, deep value is almost impossible to find unless you delve into the deepest junk sections of the market. This screen yields more results and opportunities.
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) greater than 1.5. This is designed to screen for companies with strong balance sheets.
- Long-term debt < 1.1 times 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.?
Meeting the criteria
In the first article of this series, I covered Kelly Services Inc. (KELYA, Financial), which appeared to meet all of the criteria and looked to be undervalued by around 25%.
With a market capitalization of around $816 million at the time writing, Kelly is a relatively large business compared to the next candidate, CSS Industries Inc. (CSS, Financial)
CSS has a market capitalization of $246 million and an enterprise value of $197 million. For fiscal 2017, the company reported earnings per share of $3.1, giving a trailing 12-month P/E ratio of just under 10. So far, there are no Wall Street estimates for fiscal 2018 or 2019.
Moving onto criteria number two, CSS has a strong balance sheet with net cash of $67 million at the end of fiscal 2017 and a current ratio of 6.5 times. With no debt, the company's long-term debt to working capital ratio is certainly below Graham's requirement of 1.1 times.
On the topic of earnings growth, the company has reported positive EPS for the past six years. Over the same period, the company has paid an average dividend of 66 cents per share per annum.
EPS of $3.10 were reported for fiscal 2017, up from $1.70 in 2012.
The company's book value per share at the end of fiscal 2017 was $32.4, indicating it is currently trading at a price-book (P/B) ratio of 0.9 and price to tangible book ratio of 1.1.
CSS has its primary listing in the U.S.
Calculating valuation
CSS ticks all the boxes on the enterprising investor list, but what about the company's valuation? Is the margin of safety wide enough for investors to buy in?
To find out, I am going to borrow a valuation method from Graham himself, as well as his various investment checklists; Graham also puts together several models for valuing shares.
This particular model is the Graham Rule of Thumb, which is a number designed to replace the more complex discount cash flow 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 EPS of $3.1, medium-term EPS growth rate of 6.3% per annum (half of the five-year average), growth multiplier of 1.5 times and a yield on 20-year AAA corporate bonds of 5.2%, this formula suggests the company's shares should be worth $46.9. This result indicates the shares are 73.6% undervalued at current levels.
Disclosure: The author owns no stocks mentioned.
