Stock Selection for the Enterprising Investor
This is the fifteenth discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link). In last week’s discussion, we discussed the fourteenth chapter, which explored Graham’s 7 requirements for Defensive Investors. This week we will discuss the fifteenth chapter, which is titled “Stock Selection for the Enterprising Investor.” I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor. Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!
Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. If you find something that has been said by another commentator interesting, feel free to respond to them with another comment. We’ve had some great discussions throughout the book club, so keep it up!
ModernGraham’s Comments
Ben
This chapter and the last one are the two chapters of the book which influenced the development of this website the most. Graham’s techniques have been proven throughout the years by many super-investors, and ModernGraham is devoted to determining the best way to utilize Graham’s methods in today’s market environment. This chapter in particular inspired the modernization of the requirements for Enterprising Investors, and let’s take a look at the different ways I have updated each requirement:
1. Financial Condition – Graham listed two different parts to this requirement, and I have split it into two distinct tests. First, Graham required that “current assets [be] at least 1 1/2 times current liabilities.” In other words, the current ratio must be 1.5 or greater. Second, Graham said Enterprising Investors should seek companies with “debt not more than 110% of net current assets” (current assets less current liabilities). I’ve created two separate requirements out of this section simply because Graham used the word “and” when describing the two parts, indicating the company must pass both parts in order to have a strong financial condition.
2. Earnings Stability – Graham required companies to have “no deficit in the last five years” and the ModernGraham approach is no different. One of the 7 Key Tips to Value Investing, indeed the greatest of them all, is to not lose money. The same can be said about the companies in which we invest, as if a company is losing money then by definition it is not earning a return on the investment. Therefore, it is critical for a company to maintain a solid level of earnings stability.
3. Dividend record – In order to actually be an investment, there must be some return on the investment. Dividends are the surest way to receive a return on equities, as the prospect of capital gains is at least somewhat speculative while regular dividends from the most stable of companies are quite a bit more certain. As a result, ModernGraham has not modified this requirement at all, and a company must pay at least some dividend in order to qualify for Enterprising Investors.
4. Earnings Growth – Graham required companies demonstrate at least a minimal amount of earnings growth over a five year period, and the ModernGraham approach is no different. So long as a company is growing at least a little bit, it should be worthy of further inspection, but if a company is smaller today than it was five years ago there should be serious questions about the long-term prospects of the company. Five years should be long enough for any solid company to demonstrate at least the smallest amount of growth.
5. Price – This is the one requirement where ModernGraham has moved away from Graham’s original tests. Graham required the price to be “less than 120% net tangible assets.” It is our view that with the rise of the internet and the increased materialist culture worldwide, there has been a significant and tangible increase in the actual value of intellectual property – the so-called “intangible assets.” Today’s companies can earn serious income through the licensing of intellectual property, especially in comparison to companies from ages past. As a result, ModernGraham has removed the tangible assets requirement but still highly recommends paying close attention to a company’s reported value of intangible assets. The concern with intangible assets has always been the difficulty in which to value the assets, and the ease at which a company may artificially increase its balance sheet, and that concern remains in the market today. It just may not be enough of a concern today as it was in the past because of the actual and apparent value in a company licensing out its intangible assets.
Discussion Questions
Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.
- What quote from this chapter do you think best summarizes the point Graham is making?
- What do you think of Graham’s original requirements for Enterprising Investors? Do you agree with the changes I’ve made for the ModernGraham approach?
- Are there any other “modernizations” you would make to Graham’s requirements?
- What did you think of the chapter overall?
Next Week’s Discussion: Chapter Fifteen
Chapter Title – Convertible Issues and Warrants
When reading the next chapter, try to think about how the concepts Graham presents in the chapter could apply to your own investments, whether you consider yourself a Defensive Investor or an Enterprising Investor.
What are some other ways to participate?
If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.
In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!
1. What quote from this chapter do you think best summarizes the point Graham is making?
It would be rather strange if – with all the brains at work professionally in the stock market – there could be approaches which are both sound and relatively unpopular. Yet our own career and reputation have been based on this unlikely fact.
2. What do you think of Graham’s original requirements for Enterprising Investors? They appear sound in that he has lowered the defensive investor’s maximum P/E and P/B values qualifying a stock for purchase while relaxing the other requirements laid out for the defensive investor. In other words, he has required a significantly larger margin of safety for taking on more risk with companies having less conservative fundamentals.
3. Do you agree with the changes I’ve made for the ModernGraham approach? Not entirely. I believe Graham’s principles for stock selection are timeless in that they are just as valuable today as they were for him throughout his investing career. Of course that will not be a popular notion as Dr. Graham pointed out in his quote answering question one.
4. Are there any other “modernizations” you would make to Graham’s requirements? Not sure if this can be called a modernization, but the flexibility Dr. Graham built into the P/E and P/B criteria for the defensive investor would seem to hold true for the enterprising investor as well. In other words, the formula for the defensive investor’s maximum purchase price could be modified to fit Dr. Graham’s enterprising investor constraints as follows:
Defensive Investor: P/E3 x P/B < 22.5 based on his stated max P/E3 = 15 and max P/B = 1.5
Enterprising Investor: P/E3 x P/TB < 10.8 based on his stated max P/E3 = 9 and max P/TB = 1.2
It is easy to see why the expected return would be higher for the enterprising investor with a P/E3 implying a minimum required earnings yield of 11.1% as opposed the defensive investor accepting an earnings yield of as little as 6.7%. The only other factor I may consider to relax this requirement would be the growth rate of earnings as I explained in my comments for chapter 14.
5. What did you think of the chapter overall? Excellent as always.
1. What quote from this chapter do you think best summarizes the point Graham is making?
“But to the objective observer the failure of the funds to better the performance of a broad average is a pretty conclusive indication that such an achievement, instead of being easy, is in fact extremely difficult.”
2. What do you think of Graham’s original requirements for Enterprising Investors? Do you agree with the changes I’ve made for the ModernGraham approach?
To start with, I like Graham’s original requirements for Enterprising Investors. Regarding the changes you’ve made for the ModernGraham approach, I would say I agree with them and that they seem reasonable.
3. Are there any other “modernizations” you would make to Graham’s requirements?
Maybe a shift from net tangible assets to earning power could be deemed reasonable for some companies, and thus setting a maximum earnings multiplier. I’m not really sure what this maximum should be, maybe 25 times normalized earnings per share.
4. What did you think of the chapter overall?
Great chapter.
This post has also been published at http://hurricanecapital.wordpress.com.
1) What quote from this chapter do you think best summarizes the point Graham is making?
“It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone – after deducting all prior claims, and counting as zero the fixed and other assets – the results should be quite satisfactory. There were so, in our experience, for more than 30 years – say, between 1923 and 1957 – excluding a time of real trial in 1930-1932.” I love this simple statement. If you pay less for a company than its current assets, you will do well in the long run with a diversified group. It is when people get caught up with hype that they get in trouble.
2) What do you think of Graham’s original requirements for Enterprising Investors? Do you agree with the changes I’ve made for the ModernGraham approach?
-1- I agree that it makes an easier idea to separate out the two measurments.
-5- I agree with the view on intellectual property.
3) Are there any other “modernizations” you would make to Graham’s requirements?
I do not feel that there is a need to modernize any other requirement from Graham. As I mentioned in the previous chapter, I like to look at the interest coverage ratio and how long senior management has been with the company.
4) What did you think of the chapter overall?
This is a great foundation chapter. Can anyone shed a little light on Related Hedges for me, or can you direct me to information about it? I am interested in learning more about it, and the book was a little vague on it.