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Graham Revisited

Last December I reviewed the stock screener and found nine stocks that fit Benjamin Graham's guidelines for defensive investors. In this article I look at how these stocks have performed and provide this year's list of candidates.

Graham outlined his rules for defensive investors in The Intelligent Investor (ISBN 0060155477) which was first published in 1949 and can still be found in bookstores today. Graham's time tested rules are outlined in Figure 1 and should only be applied to industrial stocks. Unfortunately, few stocks meet Graham's stringent rules for earnings growth at a low price and his method often rejects all stocks as unsuitable.

Figure 1: Benjamin Graham's Criteria for the Defensive Investor
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value over 0.
Current Ratio over 2.
Earnings growth of 33% over 10 years.
Uninterrupted dividends over 20 years.
Some earnings in each of the past 10 years.
Revenue of more than $100 Million (1950).
Source: The Intelligent Investor (pages 184-185).

The stock screener uses only five years of data on each stock and, as a result, Graham's rules were trimmed down (See Figure 2). Even with these relaxed rules only nine stocks were found last year.

Figure 2: Screening criteria used to approximate Graham's rules
P/E Ratio less than 15
P/Book Ratio less than 1.5
Book Value more than 0.01
Current Ratio more than 2
5 Year Earnings Growth more than 15%
5 Year Dividend Growth more than 0%
5 Year P/E Low more than 0.01
1 Year Revenue more than $400 Million

By August last year's Graham stocks no longer qualified as defensive investments. Why? At the time, they had all increased in price and, as of August 16, had achieved an average capital gain of 39.7%. Regrettably, September was difficult and by October 29 the stocks had returned only 20.4% (See Table 1). Mind you, +20.4% is still far ahead of the S&P 500 which was down 21.2% in the same period.

Table 1: Performance of the December Picks (12/12/00 to 10/29/01)
Symbol Dec Price Oct Price Capital Gain Annual Dividend Total Return
AIR$11.94 $8.10 -32.2% 0.10 -31.5%
HVT$10.06 $12.55 24.8% 0.21 26.3%
LZB$15.88 $17.90 12.7% 0.36 14.4%
RLC---- bought out ----82.0%82.0%
RS$25.13 $23.99 -4.5% 0.24 -3.8%
TG$15.56 $18.65 19.9% 0.16 20.6%
THO$19.69 $32.90 67.1% 0.08 67.4%
WNC$7.81 $7.40 -5.3% 0.04 -4.9%
WSO$11.35 $12.80 12.8% 0.10 13.4%
Average Gain: +19.7% +20.4%
S&P 500 -22.2% -21.2%
Source:, Total Return = Capital Gain + 0.75*Annual Dividend

Of last year's picks, Rollins Truck (RLC) was the clear winner having gained 82% by the time it was bought by Penske Truck. Thor Industries (THO) was also strong, up 67.4%, due to acquisitions and improved investor confidence. The big loser of the year was AAR Corp (AIR), a trader of used aircraft, who's stock was up nicely this summer but fell by over 50% after the tragic events of September 11.

The new list of Graham stocks found by the stock screener is shown in Table 2. There are only five candidates this year which indicates that stocks, as a whole, are still expensive. Only Haverty Furniture (HVT) remained a good defensive pick despite a gain of 26%. I mentioned MDC Holdings (MDC) as a potential purchase in the Rothery Report and it remains my favorite of this year's Graham stocks.

Table 2: U.S. listed stocks that pass Graham's tests as of the close of 10/29/01 from
Company Price P/E P/E 5Year Low P/Book 5Year Earnings Growth Current Ratio 1Year Revenue (M) 5Year Dividend Growth
Centex Corp (CTX) 39.45 7.1 4.1 1.33 27.23 4.8 7,281 9.11
Domtar Inc. (DTC) 8.19 10.4 6.8 1.19 25.42 2 3,040 7.84
Haverty Furniture (HVT) 12.80 13.3 5.9 1.45 19.61 2.6 666 5.6
M.D.C. Holdings (MDC) 27.35 4.9 2.6 1.16 48.62 2.5 1,988 14.84
Pulte Homes (PHM) 33.83 5.8 3.4 1.47 17.24 2.5 4,684 6.53

As always, before investing, discuss any move with your financial advisor and check for any changes. The screener requires a small download but you'll find that it is well worth the time.

Capital preservation is hard at the best of times and Figure 3 shows that it may be impossible under current circumstances. Market declines tend to end when the market's price-to-earnings ratio falls below ten which is much lower than the present level near 29. More disturbing, despite market weakness, the S&P 500 is still as expensive as it was in 1929 and even with stable earnings it would require a 65% fall to achieve a price-to-earnings of ten. For this reason, I am pessimistic and fear that most equity investors are likely to lose money in the next decade.

As noted in my previous Canadian MoneySaver article, I suggest reducing debt and considering spending more. Personally, my portfolio is still about 85% in stocks and I hope to ride through with a combination of careful stock selection, control and patience. Selecting individual stocks that are inexpensive in relation to stable earnings or tangible book value and that have little debt should help to ensure both corporate and portfolio survival. Also, by holding individual securities I can time purchases and sales to minimize taxes and avoid some of the pitfalls associated with mutual funds. With funds, other unit holders may run for the exit and force the manager to sell low or they may harangue the manager into buying more flashy and expensive stocks. Finally, as opposed to most retirees, I am still young and hope to be investing for the next fifty years. As a result, I can be more patient and ride through a prolonged downturn. However, even with these advantages, obtaining a positive real return will be challenging.

Figure 1

Additional Resources:

First published in the December 2001 edition of the Canadian MoneySaver magazine.

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