Investing is part art, part science. And while not every decision can be based on a single number, there are several quantitative metrics investors can use to guide their selection process. Many famous value investors have proposed their own formulae in the past, including Benjamin Graham, widely acknowledged to be the father of value investing. In his book, "The Intelligent Investor," he laid out seven tests that defensively minded investors should use when deciding to buy a stock.
Adequate size of the enterprise
“All our minimum figures must be arbitrary and especially in the matter of size required. Our idea is to exclude small companies which may be subject to more than average vicissitudes, especially in the industrial field.”
The larger the business, the more stable its earnings and cash flow. A behemoth like AT&T (T, Financial) is unlikely to post a massive earnings surprise, but neither is it likely to significantly underperform expectations. By contrast, a small-cap telecommunications provider is going to be subject to much greater earnings fluctuations.This isn’t to say smaller companies can’t be value plays, but they are less likely to appeal to defensive investors.
A sufficiently strong financial condition
“For industrial companies, current assets should be at least twice current liabilities—a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or 'working capital'). For public utilities, the debt should not exceed twice the stock equity (at book value).”
The current ratio is a measure of liquidity, calculated by dividing current assets by current liabilities. A good ratio indicates the company has a lower risk of insolvency, which is obviously something a defensive investor would want to avoid.
Earnings stability
“Some earnings for the common stock in each of the past 10 years.”
Graham lived in a time when positive earnings were considered a prerequisite for a company to be considered worthy of investment. While large sections of the investing public have since jettisoned that idea (see Tesla (TSLA, Financial), Uber (UBER, Financial), Lyft (LYFT, Financial) and the soon-to-be-public WeWork), it would behoove them to remind themselves of his work.
Dividend record
“Uninterrupted payments for at least the past 20 years.”
This is one metric that is, perhaps, a little dated. Over the last several decades, companies have increasingly opted to return money to shareholders via stock repurchases, rather than dividends. Accordingly, not paying a dividend is no longer the warning sign it once was. Conservative investors, however, are often those who look for a steady stream of cash, and may have a preference for dividends anyway.
Earnings growth
“A minimum increase of at least one-third in per-share earnings in the past 10 years using three-year averages at the beginning and end."
Graham was skeptical of the idea one could accurately predict earnings growth (again, contrast this with the rosy expectations most sell-side analysts have for some of the glamour stocks out there). He did, however, want to see a company becoming more and more profitable, as that was an indication it was at least headed in the right direction.
Moderate price-earnings ratio
“Current price should not be more than 15 times average earnings of the past three years."
A low price-earnings multiple is not a sufficient reason to buy a stock, but it is a good prerequisite to bear in mind. The historical average for the S&P 500 is around 15, and that has been true for a surprising amount of time (the data dates back to the late 19th century). That may be where Graham got his suggested figure from. Of course, price-earnings ratios differ by industry, so you would want to make sure you are not buying a stock that is overvalued relative to its competition, even if it is cheap relative to the index.
Moderate ratio of price to assets
“Current price should not be more than 11 1â„2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 11 1â„2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)."
Although the rise of technology companies has made price-to-asset ratios somewhat less relevant than they used to be, they are still very useful when valuing businesses in capital-intensive industries such as energy, manufacturing, transportation and consumer staples, which are sectors that have historically appealed more to defensive investors.
Disclosure: The author owns no stocks mentioned.
Read more here:
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