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I've been re-reading The Intelligent Investor with the goal of quantifying Benjamin Graham's guidance. My goal is to develop a framework (okay, spreadsheet) with key metrics consistent with Graham's way of thinking.
In this book, Graham outlines suggested requirements for defensive investors (aka passive investors) in selecting stocks and building a stock portfolio. These guidelines could be passed along to a financial advisor as a way of specifying requirements. The big idea is to develop a checklist or screen of some sort that enables me to rely on reason rather than emotion when buying and selling stocks.
I thought it'd be interesting to apply Graham's guidelines to a stock screen using tools provided by brokerage firms. Let's look at some of the criteria mentioned by Graham:
- Conservatively Financed
As I'm considering how to find such companies, I'll look at stock screeners and other tools offered by Fidelity, Schwab, TD Ameritrade, and Vanguard.
How to Find Large Companies
To identify large companies, I'm going to start with the idea that large companies could be the same as “large caps” or those with a market capitalization that's, say, $5 billion or perhaps $10 billion or more. Interestingly, financial experts and brokerage firms define large-caps at surprisingly variable levels from a few billion dollars to more than twenty billion. In addition, really large companies, called “mega caps” with market capitalization of $200 billion or more may match an investor's view of “large.”
To determine market capitalization, multiply a company's stock price by its outstanding shares. For example, the market cap of Apple is $174.59 (share price) x 5,090,000,000 (5.09 Billion, number of outstanding shares) = $888+ billion. Apple could be considered a large-cap company or a mega-cap one.
If using a stock screening tool to find “large” companies at Schwab, look for market-capitalization criteria and select “large cap.” Alternatively, specify a certain capitalization, such as $300 billion and above. At Vanguard, I'm limited to selecting stocks with a market capitalization of $5 billion or more. At Fidelity, large-cap companies are those with market capitalization of $22.28 billion and more whereas TD Ameritrade uses $5 billion as its minimum.
One word of caution: theoretically, a company could fall under “large-cap” but not really be large. Its stock price could skyrocket based on excitement, not underlying financials. For a short period, its market capitalization could exceed $5 billion but then fall suddenly and become a mid-cap or small-cap overnight. Still, the “large” standard is just one of the criteria in which to consider when purchasing stock as a defensive investor.
How to Find Prominent Companies
Defining and locating a prominent company is more difficult than finding large companies. Graham's definition is straightforward: the company should rank in the top quarter or third of its industry group.
Sadly, screening tools don't offer easy ways to identify top-ranked companies in terms of annual revenues or assets. However, Fidelity and TD Ameritrade provide details about selected stocks that allow me to identify whether a particular company might be considered prominent. That is, I can't set a screen to identify top-tier companies in an industry but I can use other tools to locate them. Plus, these firms provide methods of evaluating a company in comparison to its peers.
One of the best tools is offered by TD Ameritrade under its “Peer Comparison” of a selected stock. There are comparisons of the following (and more):
- Market Cap
- Dividend Yield
- Total Revenue
- Profit Margin
- Earnings Growth
- Revenue Growth
To identify which companies are the big players in an industry, I'd look at “Total Revenue” and possibly “Market Cap” (though I think of market cap as being less relevant because it reflects the market's view of its size, not the prominence of its sales or market share). The other info, such as profit margin, is useful but doesn't indicate prominence.
Another nice tool is presented by Fidelity under “Key Statistics” for specific stock picks. There I can see how a company and its stock stack up in terms of “Industry Percentile.” To determine whether a company is a prominent one, I'll look for businesses in the top 70-75% in these areas:
- Market Cap
- Free Cash Flow
Again, there's more useful information but right now I'm looking for statistics pertaining to relative size only.
Note that there are certain companies with innovative products that aren't easily categorized and may not have peers; however, these companies are not likely to be ones suitable for a defensive investor.
How to Find Conservatively Financed Companies
To identify conservatively financed companies, I'll need to do some calculations, drawing numbers from balance sheets, and/or apply criteria associated with debt load using screening tools.
In an earlier article, I discussed how I find beauty in balance sheets. There I checked debt but also looked at how the balance sheet supported and reflected the company's operations over time. Right now, I'm considering “conservative financing” by looking at a moment in time, a snapshot rather than a story that's unfolding.
Graham suggests a definition of conservatively financed when “common stock (at book value) is at least half of total capitalization, including bank debt.” I classify long-term debt as bank debt whereas accounts payable balances represent debt associated with vendors (bills due but not yet paid). In addition, Graham's rules can be relaxed or modified depending on the industry (according to Graham himself, not me); for example, utility companies may have higher debt as they typically have a persistent need for financing of infrastructure improvements along with relatively steady income from customers that consistently use its services.
Spreadsheet Calculations using Balance Sheets
Spreadsheet calculations to figure conservative financing could look like this:
- Common Stock (at Book Value) = (Assets – Liabilities) / (Outstanding Shares of Common Stock)
- Capitalization, including Bank Debt = (Shareholders' Equity + Long-Term Debt) / (Outstanding Shares of Common Stock)
- Calc 1 / Calc should be 50% or more to be considered “conservative”
Looking at Google/Alphabet (GOOGL), which has very little debt, here's are figures from the balance sheet (rounded, in millions):
- Assets: $167,000
- Liabilities: $28,000
- Shareholders' Equity: $139,000
- Long-Term Debt: $4,000
- Outstanding Shares: 691
leading to these calculations:
- ($167,000-$28,000)/691 = 201
- ($139,000+4000)/691 = 207
- 201/207 = 97%
At 97% (more than 50%), Google/Alphabet would pass the hurdle of being conservatively financed.
Screening Criteria involving Debt Ratios
Alternatively, I could use criteria on stock screening tools: Debt to Equity (which compares debt to shareholders' equity) or Debt to Capital (which compares debt to shareholders' equity plus debt). Using this approach, I'll want my ratios to be low, not high. For example, again using Google/Alphabet, debt to equity is $4,000/$139,000 = 2.88 and debt to capital is $4,000/($139,000+$4,000) = 2.80. There may be nuances to the way these ratios are calculated and presented by brokerage firms but these numbers should approximate the ratios. Basically, less debt is better than lots of debt as a percentage of assets.
To identify large and conservatively financed companies using brokerage firms' screening tools, here are examples of my selections:
- “Basic Criteria” > “Market Capitalization” > Select “Large”
- “Financial Strength” > “Debt to Equity” > Select “No Debt” and “<1” (less than 1)
- “Basic Company Facts” > “Market Capitalization” > Select “Large” and “Mega-Cap”
- “Management & Growth” > “Debt to Capital Ratio” > Select “Very Low,” “Low,” and “Medium” or specify a range, such as 0% to 50%
- “Basic” > “Market Capitalization” > Select “Large Cap”
- “Valuation” > “Debt to Capital” > Select “0-25%” and “25-50%”
Results generated can then be analyzed for prominence. So, I'd use the screening tools to find companies that are large and conservatively financed, and then I'd sort these companies by market cap (or other size criteria) to identify the top-tier ones. Using this method, I'd have a list of companies for further consideration.
Graham suggests classic rules for investors in The Intelligent Investor. Here I've analyzed what I believe he means when he recommends the criteria of large, prominent, and conservatively financed.
Through this process, I have been fascinated to learn that many screening tools focus more on short-term results and technical movement (that is the biases of “Mr. Market”) than fundamentals.
As far as my personal preferences, I definitely favor companies that are conservatively financed. I tend to like ones that are large and prominent though I haven't consciously added those criteria to my stock-selection list. However, when I've chosen within established guidelines, I've been more apt to choose wisely. So, to Graham's point, a disciplined investor first determines criteria and then find selections that match these criteria.
Disclosure: I'm long on GOOGL.
Do you like large, prominent, and conservatively financed companies? What criteria do you use when making stock buying decisions?