3 Investments That Benjamin Graham Might Like

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Benjamin Graham is the godfather of value investing and was Warren Buffett's mentor. Unfortunately, as he is regularly cited as the reason for Buffett's success, many people try to mimic his investing style, which is set out in his book The Intelligent Investor.

But with so many trying to copy his techniques, many have misread facts, often looking for quick fixes to beat the market and get ahead of the game. It is not that simple.

Still, opportunities exist, and we'll take a look at three stocks that might have been to Graham's liking below. But first ...

Ben Graham's criteria

These are the original criteria that Graham set out in his book in order to find securities that are suitable for the defensive investor.

1. Adequate size of enterprise

  • $100 million annual sales for industrial company; $50 million for public utility

2. Sufficiently strong financial position

  • Current ratio of no less than 2
  • Long-term debt should not exceed net current assets (working capital)
  • Utilities debt should not exceed twice the stock equity

3. Earnings stability

  •  Some earnings for the common stock in each of the past 10 years

4. Dividend record

  • Uninterrupted payments for 20 years

5. Earnings growth

  •  A minimum of 30% increase in earnings over 10 years (with beginning and end values taken as averages over three years)

6. Moderate P/E ratio

  • No more than a P/E of 15 of average earnings over the past three years

7. Moderate ratio of price to assets

  •  Book value should be no more than 1.5 times

The criteria are very strict and many investors nowadays do not bother to conduct such in-depth analysis when considering a prospective investment.

It is also useful to note that Graham uses three-year averages when evaluating a company on its P/E ratio, which helps to smooth out any one-off items that could cause the P/E to give an abnormally high or low figure for the year in question.

Are there opportunities that meet the criteria?

With both the Dow and S&P 500 currently bouncing around their all-time highs, there are very few opportunities in the market that meet Graham's criteria.

However, after some careful research, I have come up with three stocks that almost meet the criteria, although I have had to bend the rules a bit as some of my data does not go back far enough.

Note: At the time of writing, the ratios for these companies were correct. It is possible that the share prices will move significantly between writing and publication. If that is the case, it is possible that the companies below could no longer meet the strict criteria set out above.

Contender number 1: HollyFrontier

Petroleum refiner HollyFrontier (NYSE: HFC) meets the first criteria easily with $20.2 billion in revenue during 2012. The company has a strong financial position with a current ratio of 2 and working capital of $2.8 billion, which is more than double the company's long-term debt of $1.3 billion.

The company has produced some positive earnings in each of the past 10 years and has paid a dividend for 10+ years, which is as far back as my data goes.

In respect to EPS growth, the company had average earnings per share of $0.73 between 2003-2005 and average EPS of $5.30 between 2009-2012. Although this is not a 10-year period, it is as far as my data goes and it is a staggering rate of growth, far exceeding the 30% growth required for Graham's criteria.

In terms of financial ratios, the company has a P/E of 6.1 at the time of writing and a price-to-book ratio of 1.7. That's higher than the ratio of 1.5 that Graham requires. However, Graham does state that it is possible to use a P/B that is higher than 1.5, as I'll explain below.

Contender number 2: Universal

Up next is Universal (NYSE: UVV), a producer of tobacco that is sold to cigarette manufacturers throughout the world.

The company has adequate size, with revenues over $2 billion, and is financially stable with a current ratio of 2 and working capital of just under $1.3 billion, compared to its total debt pile of $536 million.

As far as I can tell, the company has produced some earnings for the past nine years and has issued a dividend for the past 40 years. Over the past 10 years the company's earnings per share have grown 83%, with three-year averages taken at the beginning and the end of the 10-year period.

Universal has a trailing 12-month P/E ratio of 12.3 and a price-to-book ratio of 1.1, making the stock look like a perfect pick for Benjamin Graham.

Contender number 3: Weis Markets

Weis Markets (NYSE: WMK) meets the first criteria, generating over $2 billion in revenue during 2012. The company has a current ratio of 2.2 and no debt. Weis has produced some earnings for each of the past 12 years and has paid a dividend since 2000 (as far as my data goes).

Between 2002-2005 the company produced average EPS of $2.1 and between 2009-2012 the company produced average EPS of $2.8, which is a growth rate of 33% - only slightly above Graham's criteria.

Weis currently trades at a P/E of 14 at the time of writing and a P/B of 1.4, both of which are both under Graham's maximum limit.

The final test

As a rough guide, it is possible to use the Graham number to establish a price target for a share that could be a suitable Graham-style investment.

The Graham number came about as a way of calculating the fair value of a stock. If the current share price is under the calculated Graham number, then the stock is cheap and can be brought as a value investment. However, if the stock is trading above the Graham number, then the stock is expensive and should be sold.

Graham Number = Square Root of (22.5 x Book Value Per Share x Earnings Per Share)

The square root of 22.5 signifies Graham's belief that the P/E ratio should not be greater than 15 and the P/B no greater than 1.5 (15*1.5=22.5), while still making allowances for either of those ratios to be slightly higher, if offset by the other.

So how do these three companies compare?

Company

P/E ttm

EPS ttm

Book value per share

Graham Number

Weis Markets

13.8

3.1

29.6

$45.4

Universal

12.3

4.7

53.5

$75.2

HollyFrontier

6

8.4

29.7

$74.9

All three companies are currently trading below their Graham numbers and offer some potential upside before a full valuation.

Summary

Graham's criteria may be strict, but opportunities can be found in any market. It just requires a little extra work. At the time of writing, these three companies all meet the strict criteria and all offer prospective upside based on their low valuations and solid balance sheets.

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Fool contributor Rupert Hargreaves owns shares of HollyFrontier. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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