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The enterprising investor's screen

Graham's looser tests for an enterprising investor, what his single-factor experiments found, and the advice to practise on paper first.

FinanceGraham ch. 15About 7 min: 4 reading, 3 practiceUpdated

General education, not financial advice.

After this lesson you can
  • List the tests Graham applied to low-P/E stocks for an enterprising investor
  • Explain what his single-factor experiments and random portfolios showed
  • Describe Graham's practice year and Zweig's 10% limit
The Intelligent Investor: Benjamin Graham's ideas: lesson 16 of 24
  1. Graham ch. 1
  2. Investment versus speculation 4 min
  3. Graham ch. 2
  4. Inflation and the investor 4 min
  5. Graham ch. 3
  6. A century of market history 5 min
  7. Graham ch. 4
  8. The defensive investor's portfolio 4 min
  9. Graham ch. 5
  10. Defensive investors and stocks 4 min
  11. Graham ch. 6
  12. What the enterprising investor avoids 4 min
  13. Graham ch. 7
  14. What the enterprising investor does 5 min
  15. Graham ch. 8
  16. Mr. Market 5 min
  17. Living with fluctuations 5 min
  18. Graham ch. 9
  19. Investing in funds 5 min
  20. Graham ch. 10
  21. The investor and his advisers 4 min
  22. Graham ch. 11
  23. Security analysis for the lay investor 4 min
  24. Graham ch. 12
  25. Per-share earnings and their traps 4 min
  26. Graham ch. 13
  27. Comparing four companies 4 min
  28. Graham ch. 14
  29. The defensive investor's screen 4 min
  30. Graham ch. 15
  31. The enterprising investor's screen 7 min
  32. Graham ch. 16
  33. Convertibles and warrants 6 min
  34. Graham ch. 17
  35. Four extreme case histories 7 min
  36. Graham ch. 18
  37. Eight pairs of companies 7 min
  38. Graham ch. 19
  39. Shareholders, managements and dividends 5 min
  40. Graham ch. 20
  41. Margin of safety (1): the idea 5 min
  42. Margin of safety (2): in practice 7 min
  43. Graham appendix 1
  44. The superinvestors of Graham-and-Doddsville 6 min
  45. Graham postscript
  46. Graham today 7 min

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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 15, "Stock Selection for the Enterprising Investor"

What it is

Graham opens the chapter with a warning: most stock funds, with the best analysts available, had failed to beat the market averages over long periods. Picking better-than-average stocks is hard, he says, and readers should not expect to out-select the country's top analysts. His hope lies in parts of the market that the usual methods neglect.

His sample screen (end of 1970). Graham went through Standard & Poor's Stock Guide looking for stocks at 9 times recent earnings or less, then applied five more tests, looser than the defensive ones:

  1. Financial condition: current assets at least 1.5 times current liabilities, and debt no more than 110% of net current assets.
  2. Earnings stability: no loss in the last five years.
  3. Dividend record: some current dividend.
  4. Earnings growth: last year's earnings higher than four years earlier (1966).
  5. Price: less than 120% of net tangible assets.

There is no minimum size: small companies, Graham says, can be safe enough if bought carefully and as a group. From the first 450 or so issues in the Guide, the screen produced 15 stocks, which he presents for illustration only.

Quick check

Tap an answer to check it.

  1. A company has net current assets of 100 and debt of 105. Does it pass Graham's enterprising debt test?

    Show answer

    Yes: the limit is 110% of net current assets, which is 110. The enterprising tests are deliberately looser than the defensive ones.

Why it matters

Single-factor experiments. Graham also tested 30-stock portfolios chosen on one criterion each (low P/E, high dividend, long dividend record, large size, strong finances, low share price and so on), bought at the end of 1968 and valued in mid-1971. His findings:

  • Random stocks did badly. Ninety stocks chosen at random fell an average of 22%, not counting those that dropped out of the Guide, while the S&P composite was about flat. Graham's lesson: avoid second-quality issues unless they are demonstrable bargains.
  • On the whole, a list chosen for a favourable factor did better than one chosen for the opposite factor.
  • To his surprise, the best group was the "good-will giants": huge companies selling far above book value. Graham reports this finding but keeps his own preference for stocks with asset values of at least two-thirds of the price.

Bargain issues. Stocks bought below net current asset value had served Graham well for over 30 years. The 1970 fall brought some back, including well-known brand-name companies. His conditions: enough of them to diversify, and the patience to hold when they don't rise soon.

Workouts. Mergers and liquidations can offer a known profit if the deal completes. But an increasing share of announced deals fail, and Graham concludes this has become a field for professionals.

Zweig's commentary. He says most people do not need to pick stocks at all. For those who want to:

  • Zweig passes on Graham's advice to practise for a year on paper, and adds: compare the results with an S&P 500 index fund.
  • If the picks did well and the work was enjoyable, keep stock picking to at most 10% of the portfolio, with the rest in an index fund.
  • Zweig reports that several value fund managers look where others are selling, starting from lists of new 52-week lows.
  • He reports that leading managers also judge management: are the accounts clear, and do "one-off" charges keep coming back?

Worked example

Graham's Kayser-Roth example (January 1971): Borden offered 1⅓ of its shares for each Kayser-Roth share. Borden closed at 26 and Kayser-Roth at 28.

  • Buy 300 Kayser-Roth at 28: cost 8,400.
  • Sell 400 Borden at 26 (300 × 1⅓ = 400 shares): receive 10,400.
  • If the deal completes, the 300 Kayser-Roth become the 400 Borden shares already sold, leaving 2,000, about 24% of the cost before commissions.

The deal did not go through: the directors rejected it. Graham estimates that unwinding at once would have cost about 12%. One failure can wipe out much of the profit from a successful deal, which is why he leaves workouts to professionals.

Common mistake

Reading the "good-will giants" result as Graham's advice to buy popular, expensive companies. He reports the finding because it was true over that period, says momentum may carry such stocks along, and still prefers stocks with substantial asset value behind the price.

Key terms

net tangible assets
net assets excluding intangibles such as goodwill
bargain issue
a stock priced below its net current asset value
workout
a holding whose profit depends on a merger, liquidation or similar deal going through
good-will component
the part of a share price above book value
52-week low
the lowest price of the past year

Practise the key terms

Tap a card to turn it over. 5 cards.

FrontBack
net tangible assetsnet assets excluding intangibles such as goodwill
bargain issuea stock priced below its net current asset value
workouta holding whose profit depends on a merger, liquidation or similar deal going through
good-will componentthe part of a share price above book value
52-week lowthe lowest price of the past year

Practice

Work it through

Price 18; earnings per share 2.25; net tangible assets per share 16; current assets 300; current liabilities 180; debt 120.

Quick quiz

Tap an answer to check it.

  1. In the last exercise, which of Graham's numerical tests does the share fail?

    Show answer

    None: P/E 8 ≤ 9, current ratio above 1.5, debt 120 within 132, price below 120% of net tangible assets. It passes all four; the earnings and dividend tests need the company's history.

  2. What did Graham's 90 randomly chosen stocks do from end-1968 to August 1971?

    Show answer

    Fell an average of 22%. Smaller, weaker issues fell further, which is why Graham says to avoid second-quality issues unless they are clear bargains.

  3. What did Graham advise, as Zweig reports it, before picking stocks with real money?

    Show answer

    A year of tracking picks on paper, compared with an index fund. It shows whether you are good at it, and whether you enjoy it, at no cost.

Sort it

Which group does this belong to?

  1. Debt no more than net current assets

    Show answer

    Defensive test. The enterprising version allows 110%

  2. No loss in the last five years

    Show answer

    Enterprising test. The defensive test asks for ten years of earnings

  3. 20 years of unbroken dividends

    Show answer

    Defensive test. The enterprising test asks only for some current dividend

  4. Current ratio of at least 1.5

    Show answer

    Enterprising test. The defensive test asks for 2

  5. No minimum company size

    Show answer

    Enterprising test. The defensive screen sets a minimum size

In short

  • Graham: beating the averages is hard, even for professionals; look where others don't.
  • His enterprising screen: P/E of 9 or less, current ratio 1.5, debt ≤ 110% of net current assets, five years without a loss, some dividend, earnings above four years earlier, price below 120% of net tangible assets.
  • Random stocks fell 22%; good-will giants did best, but Graham kept his preference for asset value.
  • Bargain issues need diversification and patience; workouts are for professionals.
  • Practise on paper for a year (Graham's advice, via Zweig); Zweig limits stock picking to 10% of the portfolio.

Mastery check

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Check yourself

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  1. What P/E did Graham's enterprising screen start from?

    Show answer

    9 times recent earnings or less.

  2. What was Graham's enterprising debt test?

    Show answer

    Debt no more than 110% of net current assets.

  3. What share of a portfolio does Zweig suggest as the most to keep in individually picked stocks?

    Show answer

    10%.

Further reading