Creating the Revised Graham Enterprising Investor Screen

by Joe Lan, CFA

Benjamin Graham is famously called the father of modern value investing. His investment methodology is based on fundamental analysis see!ing companies that are undervalued. He introduced the concepts of security analysis and intrinsic value. In fact "arren Buffett one of the greatest investors of our time credits Benjamin Graham #ith being one of his strongest investing influences.
$$II currently follo#s three separate Graham screens based on Benjamin Graham%s methodologies as described in his boo! &'he Intelligent Investor( )revised edition* Collins Business +,,-.. Each of these screens has performed #ell over the long run. Ho#ever the Graham Enterprising Investor screen typically has very fe# companies that pass its filters each month and often no companies pass the screen at all. 'o address this #ea!ness and ma!e the screen more investable $$II /resident 0ohn Baj!o#s!i revised the Graham Enterprising Investor screen. His efforts can be found in the 1ctober +,2+ $$II 0ournal )available at $$II.com..

'he Graham Enterprising Revised screen not only allo#s more companies to pass than the original Graham screen but the long3term performance has also been better. Ho#ever the revised screen is not currently programmed into Stock Investor Pro $$II%s fundamental stoc! screening and research database. In this 4eature article I provide step3 by3step instructions on creating the Graham Enterprising Revised screen. 'he screen #ill be built using Stock Investor Pro but you can use any stoc! screening tool you prefer. Before #e begin let%s revie# the methodology behind the Graham Enterprising screen.

The Enterprising Investor

Benjamin Graham felt that individual investors fall into t#o camps* defensive investors and aggressive or enterprising investors. 'hese t#o groups are distinguished not by the amount of ris! they are #illing to ta!e but rather by the amount of &intelligent effort( they are &#illing and able to bring to bear on the tas!.(

4or instance he included in the defensive investor category professionals unable to devote much time to the process and young investors )his e5ample #as a sharp young e5ecutive interested in finance. #ho are unfamiliar and ine5perienced #ith investing. 6efensive investors should confine their holdings to larger companies #ith a long record of profitable operations and that are in strong financial condition. Graham believed that aggressive investors on the other hand can e5pand their universe substantially. Being a proponent of value investing though Graham recommended that purchases should be attractively priced as established by intelligent analysis. He also stated that even aggressive investors should avoid ne# issues. In &'he Intelligent Investor ( Benjamin Graham defined the enterprising investor as an individual e5perienced in investing #ho is #illing and able to put forth an &intelligent effort( in analy7ing a #ide range of seasoned stoc!s. Graham noted that there are several &fertile( areas on #hich investors should focus to find undervalued stoc!s for enterprising investors. 'he first area is large out3of3favor companies indicated by a lo# price relative to current earnings. "hile small companies may also be undervalued Graham felt they carry a much greater ris! that they #ould not be able to sustain themselves through a period of adversity. In addition he believed that the mar!et%s neglect of small firms results in slo# recognition of better earnings e5tending the period of unpopularity. It is also important to recogni7e the difference bet#een a company that is truly trading at a discount and a cyclical firm that has a lo# current price3earnings ratio because it is in a pea! year. 'he mar!et recogni7es that the price3earnings ratios of these latter companies #ill rise as earnings drop during #ea!er years. 'o avoid buying these cyclical firms he suggested searching for companies that are trading at a lo# price in relation to past average earnings. Separately Graham recommended see!ing bargain stoc!s #hich he defined as stoc!s selling at 8,9 or less of their &indicated( value. Indicated value can be calculated either by estimating future earnings

or by valuing the firm as a private business #hich includes an estimate of future earnings and places emphasis on the value of reali7able assets particularly #or!ing capital less debt. 'he most obvious bargain according to Graham is a company selling for less than its net #or!ing capital alone. In this case Graham said that the investor #ould be purchasing a firm #ithout paying for its plants and machinery or any intangibles. 1nce again Graham stressed the necessity for investors to distinguish bet#een undervalued stoc!s and those that are selling at lo# prices relative to value for a reason. Graham suggested that aggressive investors also loo! for reasonable stability of earnings over the past decade #ith no years of negative earnings and enough financial si7e and strength to allo# the firm to survive any future setbac!s. $ccording to Benjamin Graham enterprising investors could also find success investing in &secondary companies ( if their shares are purchased at bargains. Graham defined a secondary company as one that is a smaller concern in an important industry or a top firm in an unimportant industry. He noted that mid3si7ed companies fit this definition and he felt the stoc! mar!et tends to undervalue these firms. $t the same time he believed these firms are large enough to sustain themselves through various economic cycles #ith the ability to earn a fair return on invested capital. Investors #ould profit from both earnings paid in dividends and those that are reinvested. He also noted that during bull mar!et periods these firms generally return to fair valuation.

Creating the Revised Screen

4igure 2 sho#s the criteria for the original Graham Enterprising screen as programmed into Stoc! Investor /ro. $ fe# significant changes #ere made to the screen to create a larger list of passing companies #hile maintaining the characteristics of Benjamin Graham%s methodology. 'he follo#ing section dissects each portion of the Graham Enterprising screen e5plains the changes made to revise the screen and creates the screen in Stoc! Investor /ro.
Figure 1. Graham Enterprising Criteria in Stock Investor Pro

Price-Earnings Ratio
'he foundational belief of Graham%s methodology is to select stoc!s trading at a significant discount. In the original Graham Enterprising screen the first criteria used is that companies passing must be in the bottom 2,9 of all stoc!s based on price3earnings ratio. $s stated earlier Graham #arned about the lo# price3earnings filter passing cyclical firms #ith #idely fluctuating earnings. 'hese firms often trade at high prices and lo# price3earnings ratios in good years #hen they should be sold and lo# prices and high or non3e5istent price3earnings ratios in bad years #hen they should be considered for purchase. Graham recommended a test of lo# price relative to past average earnings #hich is used for the defensive investor screen. 4or the revised Graham Enterprising screen #e !ept the filter as a percentage ran! so that the figure #ill adjust as the mar!et fluctuates. :aturally this filter is very restrictive as more than ;,9 of all stoc!s #ill immediately be screened out. 'o adjust this filter in the revised Graham Enterprising screen #e screened for stoc!s #ith a price3 earnings ratio in the bottom +89 of all stoc!s.

Financial Condition
4or the enterprising investor Graham stipulated that the current ratio must meet or e5ceed 2.8 #hile long3term debt is not to be higher than 22,9 of #or!ing capital. 'he current ratio is calculated by dividing current assets by current liabilities #hile #or!ing capital is defined as current assets minus current liabilities. 'hese filters remain unchanged for the revised screen.

Earnings Stabilit
Graham re<uired that companies have a long history of earnings stability. 4or the enterprising investor Graham specified that earnings must be positive for the last five years. 6uring recessionary periods this screen may become very restrictive passing mostly firms from defensive industries. Ho#ever #e have yet to find this filter overly restrictive. 'herefore the filter #as not changed for the Graham Enterprising Revised screen.

!ividend Record
$s far as dividends go Graham re<uired only that firms pay some level of current dividends. $s you can see from 4igures 2 and + this filter passes a little over - ,,, stoc!s by itself. 'ypically only more mature companies past their stage of strong capital3intensive gro#th can afford to pay a cash dividend.
Figure ". Graham Enterprising Revised Criteria

'his filter is also designed to screen out companies #ith lo#3price earnings ratios that are under financial distress. Since this filter is not overly restrictive it is !ept the same in the revised Graham screen.

Earnings Gro#th
4or enterprising investors Graham stated that current earnings should be higher than they #ere five years ago. 'his simple filter passes around half of the universe of stoc!s and is !ept the same in the revised Graham screen.

Price-to-$ook-%alue Ratio
$ final measure of value used by Graham is the price3to3boo!3value ratio. 4or the enterprising investor Graham specified that firms should have a price3to3boo!3value ratio of 2.+ or lo#er. 'his filter allo#s for about - ,,, or so companies to pass and it #as !ept the same for the revised screen.

E&change-'raded ( !omestic
$lthough Graham preferred larger companies as investments due to their ability to #eather economic adversity he felt that enterprising investors could invest in more speculative issues such as smaller stoc!s. 'herefore there is no re<uirement for company si7e. 4or the revised screen ho#ever #e did add re<uirements that stoc!s must be e5change3listed and traded domestically. 'hese re<uirements are meant to ensure that audited and timely financial statements are available for the passing companies.

Historical Comparison o Screens

'he goal of the Graham Enterprising Revised screen is to allo# for more passing companies #hile maintaining Benjamin Graham%s vision for enterprising investors. $s sho#n at the bottom right of 4igures 2 and + #e successfully increased the number of passing companies from one to four. In addition the monthly turnover of the screen has been reduced from ==9 to +>9. 'able 2 reports the annual return and ris! characteristics of the t#o Graham Enterprising screens #hich sho#s that the revised screen outperforms the original screen over the long term. 'he revised screen also performed much better during the last bull mar!et than the original screen #hile during the last bear mar!et the t#o screens #ere nearly identical. Standard deviation is also nearly the same for the t#o screens. $dditionally it should be noted that in +,,? the revised screen had much better do#nside protection.

!assing Companies
@sing Stock Investor Pro #ith data as of :ovember +- +,2+ four companies passed the Graham Enterprising Revised screen #hereas one company passed the original screen. 'he passing companies for

both screens along #ith their fundamental data are listed in 'able +. 'able -lists the criteria used specfically in Stock Investor Pro. 'he lone passing company for the original Graham Enterprising screen is 1rient /aper Inc. )1:/. a Chinese company that no analysts compiled by IABAEAS trac!. 'his company has a mar!et capitali7ation of B-?.+ million. $lthough the price3earnings and price3boo! ratios are very lo# it is difficult to say that this company truly meets the essence of Benjamin Graham%s screen. 'he company is very small and may be overloo!ed by investors for some period of time causing a prolonged slump in price even if its prospects improve. 'he Graham Enterprising Revised screen passed four stoc!s from four separate industries. 'hree of the four stoc!s are trading at lo#er price3 earnings ratios than their seven3year historical averages and all four of the stoc!s are trading at lo#er price3to3boo!3value ratios than their seven year averages. $CC1: 6istributing Co. )6I'. and 4riedman Industries )4R6. are small #ith mar!et capitali7ations of less than B>? million but Cantech International Corp. )C$:'. and "estern 6igital Corp. )"6C. are larger companies #ith mar!et capitali7ations of B;,, million and B?.8 billion respectively.
'able ). Criteria to *se #ith Stock Investor Pro

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Concl"sion
Benjamin Graham once said that individuals #ho cannot master their emotions are ill3suited to profit from the investment process. $s a value investor he understood that good companies do not al#ays ma!e good stoc!s. His goal #as to purchase strong companies at a discount to their intrinsic value. 'he ne#ly established Graham Enterprising Revised screen is a less3 restrictive screen #hile identifying companies that have performed #ell over the long run and maintaining the spirit of Benjamin Graham%s methodology. $l#ays !eep in mind though that stoc! screening should be the beginning of the investment process. Be sure to perform due diligence #hen using a stoc! screen to ensure that the stoc!s you purchase match your personal ris!3aversion and time hori7on. Be careful #ith deep3value screens* Companies may be out3of3favor #ith investors for good reason.