Intelligent Investor Ch.15 - Aggressive Stock Selection
Stock Selection for the Enterprise Investor
The previous post, defensive stock selection, was mainly based on the exclusion of poor performing companies. This aggressive or enterprise investor selects companies that are above average and profitable.
If we remember from the previous post, to get the average, we would buy equally amount in each of the 30 DJIA companies or buy a mutual fund that buys the whole index. With a slightly moderate degree of skill, if you study enough have experience and ability - Graham mentions it should be possible to be substantially better than the DJIA!
On the other hand, there are not many investment funds or investment managers, who beat the index or are above average. There are several theories why this happens, one is that Graham takes an example of equally skilled bridge players who will win the game through "breaks" of various sorts rather than superior skill! Another theory is that all the clever investment managers buy into the same growing industries or the same growing companies at any price and avoid less promising industries and companies no matter how low the price.
So what do we have to do to be above average? Here comes a summary of the Graham-Newman Methods:
- Arbitrages
- Liquidations
- Related Hedges
- Net-Current-Asset (Or "Bargain") Issues - NCAV
Arbitrages: It is simply the purchase and sale of a security to profit from a difference in different markets or in different situations, like merger or acquisition!
Liquidations: Purchase of a security where the asset value or liquidation value per share is higher than the current market price.
Related Hedges: The purchase of any kind of convertible (bond or preferred) and the simultaneous sale ("short") of the shares into which they were exchangeable.
Net-Current-Asset Issues: The purchase of a companies stock if the Net-Current-Asset (Current Asset minus Total Liabilities) is higher than the current market price - normally where the market price is two-thirds (67%) or lower compared to the NCAV!
Secondary companies are now available as well for selection if they show a satisfactory past record but appear to hold no charm for the public.
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Let's continue and take the following criteria that Graham laid out:
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Starting to Select the "Right" Stocks
If we want to find a stock that is cheap, the first clue is to find a low price in relation to recent earnings.
Let's start with companies where the P/E is nine and below. From the 4000+ companies of the 3 major US listings with a market cap of at least $250 million, there are 1408 that meet the first criteria, here are the first twenties:
They all meet our first valuation requirement - you see even those without a P/E (those will we filter out in the next screen)
Let's continue and take the following criteria that Graham laid out:
- Financial Condition:
- Current Assets at least 1.5 times current liabilities
- Debt not more than 110% of Net Current Assets
- Earnings Stability: No deficit in the last five years (i.e. EPS positive)
- Dividend record: Some current dividends
- Earnings growth: Last year's earning more than those of 5-years prior
- Price: Less than 120% net tangible assets
The result......
Single Criteria for Choosing Common Stocks
Is there a single criterion, that we can use, to achieve better than average results? The two methods that consistently showed good long past performance in Graham's study were the following:
- Low-multiplier stocks of important companies
- Choice of a diversified group of stock selling under net-current-asset value
Graham tested other criteria as well:
The only criteria, if bought in a diverse manner, that showed quite satisfactory performance was the Bargain Issues or Net-Current-Asset Stocks, at least for the more than 30 years tested!
It is a 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 result should be quite satisfactory!
- Low-multiplier of recent earnings, not only related to DJIA companies
- High dividend return
- A very long dividend record
- Very large enterprise, as measured by the number of outstanding shares
- Strong financial position
- Low dollar price per share
- Low price in relation to previous high price
- High-quality ranking by Standard & Poor's
The only criteria, if bought in a diverse manner, that showed quite satisfactory performance was the Bargain Issues or Net-Current-Asset Stocks, at least for the more than 30 years tested!
It is a 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 result should be quite satisfactory!
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