Would Warren Buffett’s mentor buy domestic stocks today? Probably not. The father of value investing, Benjamin Graham, would have trouble recommending a single U.S. company’s shares across thousands of possibilities.

Need proof? In the fourteenth chapter of The Intelligent Investor, a classic that Mr. Buffett regarded as “…the best book on investing ever written,” Graham offered a seven-step test for stock selection. The criteria include: (1) adequate size with respect to revenue, (2) strong financial condition with respect to liquidity, (3) reasonable earnings growth over a decade (4) modest price-to-earnings (P/E) ratio of 15 or less, (5) economical price-to-book (P/B) ratio of 1.5 or less, (6) 20 years of consistent dividend payments to insure the likelihood of continuation, and (7) earnings stability vis-a-vis the absence of any losses over the previous decade.

Right off the Louisville Slugger bat, it would be extremely difficult to employ Graham’s stock screen in its entirety. The adverse impact of the Great Recession in 2008 dismisses thousands of companies on earnings-per-share losses as well as dividend cuts/suspensions. It follows that you’re not going to get 20 consecutive years of dividend durability, 10 years of earnings stability AND moderate valuations (e.g., P/B, P/E, etc.) near all-time record highs for U.S. equities. Not even from “Dividend Aristocrats.”

Can we modify the stock screen just enough to account for the atrocious effect of 2008, yet still maintain an intelligent investor’s integrity? I think so. I applied Morningstar data to U.S. companies with the following Graham-like principles:

  1. Sales of $500 Million. Granted, Graham served up $100 million as the size benchmark in his book. That said, if we utilize inflation since the time of his writing, $500 million fits the bill.
  2. Current Ratio Greater Than or Equal to 2.0. A company needs to be able to pay back its debts. That includes short-term obligations as well as longer-term ones. This measure assesses a company’s capacity to do so by evaluating current assets as they relate to current liabilities. With a current ratio at less than 2.0, a company is far more likely to get battered in a liquidity crunch.
  3. Earnings Growth Compounding at 3% (10 Years). If a company grows earnings-per-share (EPS) by at least one-third over a decade, Graham believed profits were keeping pace with inflation. Anything short of that was a no-go.
  4. Price-To-Earnings Ratio Less Than 15 For 3 Years and Price-To-Book Less Than 1.5. Graham did not view P/E 15 as a bargain. A “fair value,” however, should shield an investor from overpaying for the privilege of ownership. Same story on P/Bs below 1.5. Graham did not suggest that P/Bs below 1.5 are cheap; rather, this criterion was more about protecting against paying too much.
  5. Steady Dividend Payment Increases Since 2010. This modification on my part is far from perfect. Nevertheless, it is an attempt to remove the Great Recession from the equation, while still maintaining some allegiance to a value-orientation as well as a probability of ongoing cash flow for shareholders.

These are extremely sensible requests for one’s value investing confidence. For instance, there are well over 2000 public companies doing business in the U.S. with $500 million or more in sales. Additionally, while current ratios vary by industry type, financially healthy businesses typically have current ratios between 1.5 and 3.0. Graham’s request for 2.0 or more simply reflects a position that a firm unquestionably has what it needs to pay back debts over the next 12 months. And is it really too much to ask that a company be able to grow its net income on a per-share basis by one-third over the prior decade? Three percent annualized earnings growth is a pretty low bar.

As sensible as the above-described requests are, roughly two-thirds of the 2000-plus corporations fell out of the running due to the possibility of struggling to pay back debts. The song remains nearly identical when you ask a company to grow earnings per share at an exceptionally modest 3% compounded over 10 years; that is, roughly two-thirds of the $500 million-plus revenue club fell by the wayside. And if you aggregate the first three tests? Only 250 companies remain.

At this juncture, you may have a feel for where the modified Graham screen is heading. Can any of the remaining corporations register value-oriented prices relative to traditional metrics like book value (assets) and earnings per share (EPS)? With my Morningstar data feed, only one survived: Trinity Industries (TRN).

trn-chart

Remember the manufacturing recession and oil price decimation that was largely responsible for keeping the S&P 500 from going anywhere for 22 months (12/2014-10/2016)? Trinity Industries (TRN), an industrial conglomerate that provides products and services (e.g., railcars, railcar maintenance, rail guards, barges, energy equipment, etc.) to manufacturers and transporters, logged -67% in stock price depreciation from its 2014 high to its 2016 low. Its fall from grace and its partial recovery mirrors the Energy Select Sector SPDR (XLE).

xle-5-yrs

In essence, for one to believe that TRN is a diamond in the value rough, one would probably need to be bullish on oil as well as the sustainability of a global revival in the demand for materials. Otherwise, Trinity (TRN) remains uniquely susceptible to an economic slowdown and/or contraction. Me? I still believe that there are significant structural challenges in Europe as well as demand challenges in Asia, making it difficult to go out on a limb for conglomerates tied to global economic growth.

So there you have it. One company passes the screen. And I’m still not going to bite.

From my perspective, then, if you’re adding significantly to U.S. stock risk in May of 2017, you’re merely speculating that Amazon (AMZN) can only go higher. You’re probably betting that Facebook (FB) and Google/Alphabet (GOOG) have forged a new economic paradigm where credit cycles, business cycles and margin debt deleveraging are irrelevant. You’re likely gambling on the erroneous notion that ultra-low interest rates are synonymous with permanent bear market hibernation, as though the four ultra-low interest rate bears between 1935 and 1955 did not occur. What you’re not doing? You’re not investing intelligently the way that Benjamin Graham believed that you could.

Perhaps Graham’s old school selection methods no longer apply. According to the American Association of Individual Investors (AAII), the 10-year results for Graham’s defensive stock screen annualize at 8.5%. The S&P 500 with reinvested dividends? 6.8%.

I don’t know if U.S. stocks will power ahead from here, dismissing everything from Trump troubles to stock valuation extremes to collapsing retailers. What I do know is that central banks’ abilities to lower borrowing costs from here have been compromised by prior balance sheet expansion. What’s more, the ballyhooed transition from central bank monetary policy stimulus to federal government fiscal policy stimulus is compromised by splintering across the political spectrum.

global-central-bank-asset

What am I doing for my moderate growth-and-income clients? I continue to maintain a healthy dollop (25%) of cash and cash equivalents like Guggenheim Enhanced Short Duration (GSY). I continue to favor investment grade income (25%) over a speculative reach for yield in junk debt. And while some readers may argue that my tactical downshift from 65%-70% widely diversified stock to 50% high quality stock came early (12/18/2014), I still adhere to a quote by Graham’s most famous student (Warren Buffett): “The price you pay determines your rate of return.”

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

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