Ben Graham's Seven Statistical Requirements

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

Anyone who considers themselves a serious investor has no doubt heard of Ben Graham. A pedagogue to the world's greatest investor, his ideas are as relevant now as they were 50 years ago. If you want to be a successful investor in common stocks, Graham is the man to study.

Graham classified investors as either defensive or enterprising. Enterprising investors are willing to devote countless hours to perfecting their stock picking skills. On the other hand, not as much effort is required from the defensive investor, whose chief concerns are freedom from worry and obtaining decent returns.

There's nothing wrong with being a defensive investor. Being a student of the stock market is not for everyone. Defensive investors will not obtain the same results as enterprising investors, but their results should be satisfactory nonetheless.

In his book The Intelligent Investor, Graham outlines seven key criteria that a stock must meet in order to be included in the defensive investor's portfolio. I'm going to see how Caterpillar (NYSE: CAT), Chevron (NYSE: CVX), and BHP Billiton (NYSE: BHP) stack up against Graham's seven statistical requirements for defensive investments. 

#1: Adequate size of enterprise 

Graham's requirements for adequate size are likely out of date by now. But I think it would be safe to say that all three companies are of adequate size. If you're looking for a minimum market cap to determine if a company is of adequate size, I would say $10 billion. Companies that large can usually survive severe economic storms.

#2: Sufficiently strong financial condition

To meet this requirement Graham proposed that a company have at least a 2-1 current ratio, and that long term debt should not exceed working capital. All three companies failed this test. Although to be fair to BHP and Chevron, the requirements were intended for industrial companies. 

Chevron's current ratio of 1.6 is well above the petroleum industry average. Its total debt-to-equity ratio of 0.1 is well below the industry average. Suffice it to say that Chevron is positioned well financially relative to its competitors.

BHP and Caterpillar have current ratios that are well below their respective industry averages. Both companies have debt-to-equity ratios that are about in line with respective peer companies. BHP and Caterpillar are not positioned as well financially as Chevron is, but both companies are still on solid financial ground. 

#3: No earnings deficit in the past ten years

All three companies have posted positive earnings in each of the past 10 years. Over the past 10 years, BHP has generated, on average, $10.87 billion in profits, with 2003 profits of $1.94 billion being the lowest of any year. Profits for Chevron over the 10 year period averaged $17.7 billion, with 2003 profits of $7.23 billion being the low mark. Average profits from Caterpillar were $3.06 billion, its low year was 2009, with profits of $895 million. 

#4: Continued dividends for at least the past 20 years

In the world of dividends, stability always trumps yield. And dividends that have been paid in every quarter during the last 20 years are about as stable as they come. The dividend histories of Chevron, Caterpillar, and BHP are shown in the following chart.

<img alt="" src="" />

CVX Dividend data by YCharts

All three companies have given money back to shareholders in every year out of the last 20. This means yields from Chevron, BHP, and Caterpillar are among the most reliable in the world of stocks. Chevron currently yields 3.2% with a 27% payout ratio. Caterpillar yields 2.9% with a 33% payout ratio. And BHP yields 3.6% with a payout ratio of 38%.

#5: Ten year growth of at least 1/3 in per share earnings

For this test I calculated the 10 year growth rate by comparing the average diluted EPS for the 2000-2002 period to the average figure from the 2010-2012 period. 

All three companies pass this test with flying colors. Caterpillar's earnings per share have increased by 262% over the past 10 years. For BHP earnings per share growth over the past decade exceeded 1,000%. And Chevron's 10 year earnings per share growth rate was 303%.

#6: Price no more than 15 times average earnings of past 3 years

Once again I used diluted earnings per share in my calculations. All three companies pass this test. The ratio for BHP was 9.23, for Chevron 10.47, and for Caterpillar 11.89.

#7: Moderate ratio of price to assets

Graham stated that you should not pay more than 1.5 times net asset value for a stock. But there is an exception to that rule. The exception is this: P/E ratios of below 15 enable you to pay correspondingly more for assets.

Graham combined requirements for P/E and price/book ratios into a metric that is famously known as the Graham number. You calculate a company's Graham number by multiplying the ratio of price to the average earnings (of the past three years) by the price to book ratio. Graham's suggested upper limit for the ratio was 22.5.

Caterpillar fails the test with a Graham number of 36.6. BHP also fails, although just barely, with a Graham number of 23.25. With a Graham number of 18.23, Chevron is the only company of these three that passes the test 

Foolish final thoughts

Benjamin Graham was an absolute genius when it came to analyzing stocks. He was an enterprising investor who put massive mental efforts into finding the markets best stocks. But he knew that, while everyone wants to make money with common stocks, not everyone would enjoy spending as much time studying them as he did.

Thankfully for the defensive investors out there, Graham outlined seven key statistical requirements that a stock ought to meet in order to be included in a defensive investor's portfolio. Checking to see if a company meets the requirements is incredibly simple. 

Here, we have three companies, none of which meet all seven requirements. I'm not sure if there is a stock out there that does right now. However, all three of these enterprises come awfully darn close to meeting all seven of Grahams requirements. BHP and Chevron both appear to be cheaper than Caterpillar. But I'd bet that buying any of these companies, at current prices, will produce satisfactory returns for the defensive investor.

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Fool blogger Ryan Palmer has no position in any of the stocks mentioned. The Motley Fool recommends Chevron. 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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