The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [150]
Testing, Testing
Let’s briefly update Graham’s criteria for stock selection.
Adequate size. Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion. In early 2003, that still left you with 437 of the companies in the Standard & Poor’s 500-stock index to choose from.
However, today’s defensive investors—unlike those in Graham’s day—can conveniently own small companies by buying a mutual fund specializing in small stocks. Again, an index fund like Vanguard Small-Cap Index is the first choice, although active funds are available at reasonable cost from such firms as Ariel, T. Rowe Price, Royce, and Third Avenue.
Strong financial condition. According to market strategists Steve Galbraith and Jay Lasus of Morgan Stanley, at the beginning of 2003 about 120 of the companies in the S & P 500 index met Graham’s test of a 2-to-1 current ratio. With current assets at least twice their current liabilities, these firms had a sizeable cushion of working capital that—on average—should sustain them through hard times.
Wall Street has always abounded in bitter ironies, and the bursting of the growth-stock bubble has created a doozy: In 1999 and 2000, high-tech, bio-tech, and telecommunications stocks were supposed to provide “aggressive growth” and ended up giving most of their investors aggressive shrinkage instead. But, by early 2003, the wheel had come full circle, and many of those aggressive growth stocks had become financially conservative—loaded with working capital, rich in cash, and often debt-free. This table provides a sampler:
FIGURE 14-1 Everything New Is Old Again
All figures in millions of dollars from latest available financial statements as of 12/31/02. Working capital is current assets minus current liabilities. Long-term debt includes preferred stock, excludes deferred tax liabilities. Sources: Morgan Stanley; Baseline; EDGAR database at www.sec.gov.
In 1999, most of these companies were among the hottest of the market’s darlings, offering the promise of high potential growth. By early 2003, they offered hard evidence of true value.
The lesson here is not that these stocks were “a sure thing,” or that you should rush out and buy everything (or anything) in this table.1 Instead, you should realize that a defensive investor can always prosper by looking patiently and calmly through the wreckage of a bear market. Graham’s criterion of financial strength still works: If you build a diversified basket of stocks whose current assets are at least double their current liabilities, and whose long-term debt does not exceed working capital, you should end up with a group of conservatively financed companies with plenty of staying power. The best values today are often found in the stocks that were once hot and have since gone cold. Throughout history, such stocks have often provided the margin of safety that a defensive investor demands.
Earnings stability. According to Morgan Stanley, 86% of all the companies in the S & P 500 index have had positive earnings in every year from 1993 through 2002. So Graham’s insistence on “some earnings for the common stock in each of the past ten years” remains a valid test—tough enough to eliminate chronic losers, but not so restrictive as to limit your choices to an unrealistically small sample.
Dividend record. As of early 2003, according to Standard & Poor’s, 354 companies in the S & P 500 (or 71% of the total) paid a dividend. No fewer than 255 companies have paid a dividend for at least 20 years in a row. And, according