Playing Defense in an Overvalued Market With Ben Graham

Ben Graham was Warren Buffett’s professor in business school. Graham was also the author of one of the widely cited investment books of all time, Security Analysis, which he cowrote with David Dodd. This book is considered to be the first text on value investing and it is still read by investment analysts.

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  • Graham believed that individual investors should begin by understanding how much time they have to devote to the investment process. Graham described the difference in terms of the amount of “intelligent effort” they are “willing and able to bring to bear on the task.”

    He cited the example of a doctor who devoted a great deal of time to his profession. That would leave little time to devote to analyzing investments. He called these investors “defensive” investors and recommended they prioritize what little time they could devote to investing to the process of avoiding serious mistakes or losses.

    Finding Investments for Defensive Investors

    This week, we are presenting details of a screening process that can be applied by defensive investors. We will focus on the utility sector because that sector is generally one of the safest sectors of the stock market and generally lose less than average in a bear market.

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    The chart below shows the Utilities Select SPDR ETF (NYSE: XLU), an exchange traded fund that tracks the sector. This is a monthly chart showing the 2008 and 2009 bear market. XLU fell almost 38% in that bear market, much less than the 55% decline of the S&P 500.

    XLU

    That means defensive sectors like utilities can help preserve capital in a bear market, but all sectors are likely to decline in a bear market. Defensive sectors, however, are expected to decline less.

    Graham advised defensive investors to consider large companies because he believed large companies have the resources in “capital and brain power” to help them serve economic downturns and bear markets. We restricted our search to utilities with at least $200 million in assets.

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  • Next, Graham looked for financial strength. He recommended investing in companies whose debt to equity ratio was less than 2, indicating the company had enough equity available to cover at least 50% of its outstanding debt.

    Earnings stability was always important to Graham who wrote his first book during the Great Depression. His goal was to find companies that could avoid losses during recessionary periods. We screened for companies that delivered at least seven years of positive earnings.

    For defensive investors, income is often an important consideration. We limited our list of buy candidates to companies that have paid a dividend for at least seven consecutive years.

    Growth of income is also often important to defensive investors. Utilities deliver growth to their investors by increasing their dividends and they generally increase earnings to increase dividends. We searched for utilities that averaged earnings growth of at least 3% over the past seven years, an amount that outpaced inflation and indicated real growth in earnings.

    Finally, we looked for value. We used two filters to find value. First, we used the price to earnings (P/E) ratio and selected stocks with a P/E ratio averaging less than 17 over the past three years. Graham considered 15 to be the cutoff but we increased that to account for lower interest rates.

    Then, we used a unique indicator that Graham applied to find value. He recommended that investors multiply the P/E ratio by the price to book (P/B) ratio and only invest if that ratio is below 25.5. This accounts for his belief that investors should look at both book value and earnings.

    Now, in the long run, this screen will do better in bear markets than bull markets. Its performance has lagged the S&P 500 over the past ten years but delivered market beating returns in bear markets.

    Just 5 stocks passed our screen.

    Boardwalk Pipeline Partners, LP (NYSE: BWP) provides transportation, storage and processing services for natural gas, and natural gas liquids and other hydrocarbons (NGLs) in the US. The company’s pipeline systems contain approximately 13,930 interconnected natural gas pipelines, directly serving customers in 13 states and indirectly serving customers throughout the northeastern and southeastern United States through various interconnections with unaffiliated pipelines.

    It also owns and operates approximately 435 miles of NGLs pipelines serving customers in Louisiana and Texas. In addition, the company has underground storage caverns having aggregate capacity of approximately 205.0 billion cubic feet of working natural gas and 24.0 million barrels of NGLs.

    The long term chart below shows BWP appears to have found support.

    BWP

    Companhia de Saneamento Básico do Estado de São Paulo – SABESP (NYSE: SBS) provides basic and environmental sanitation services, supplies, and sewage services on a wholesale basis to residential, commercial, industrial, and governmental customers in Brazil.

    Recent filings indicate the company provided water services through 8.7 million water connections to approximately 24.7 million people; and sewage services through 7.1 million sewage connections to approximately 21.2 million people, as well as operated 73,015 kilometers of water pipes and water transmission lines, and 50,097 kilometers of sewer lines.

    For SBS, the long tern chart shows a potential up side break out.

    SBS

    Huaneng Power International, Inc. (NYSE: HNP), an independent power producer, generates and sells electricity and heat to the regional or provincial grid companies in the People’s Republic of China and Singapore.

    The company generates power from coal, wind, gas, oil, biomass, and hydro resources. It is also involved in the sale of coal ash and lime; loading warehousing and conveying services; port development and construction, coal mixture, and machinery leasing and repair services; installation of cold energy instrumentation; and thermal heating services.

    HNP appears to be rallying after meeting its down side target and subsequently bouncing off of support.

    HNP

    SCANA Corporation (NYSE: SCG) engages in the generation, transmission, distribution, and sale of electricity to retail and wholesale customers in South Carolina. It owns nuclear, coal, hydro, natural gas, biomass, and solar generating facilities.

    The stock recently sold off and now offers a yield of about 5.7%, well above its long term average of 3.7%. This makes the stock attractive to income investors.

    SCG

    Spectra Energy Partners, LP (NYSE: SEP) operates as an investment arm of Spectra Energy Corp. Spectra Energy Partners, LP, through its subsidiaries, engages in the transportation of natural gas through interstate pipeline systems, and the storage of natural gas in underground facilities in the United States.

    The company transports and stores natural gas for local gas distribution companies, municipal utilities, interstate and intrastate pipelines, direct industrial users, electric power generators, marketers, and producers.

    This stock could be compelling to both technical and fundamental investors.

    SEP

    The current dividend yield of 6.6% is well above the long term average of 5%, indicating SEP is potentially undervalued.

    Any of these stocks could be a potential winner and all are worth further research. For those unsure of their ability to dedicate the time to researching the market, the TradingTips.com service, PPK System, is designed to exploit patterns associated with market clues by looking for value and momentum in stocks.

    This combination of value and momentum has been shown by many researchers to be the cornerstone of strategies that beat the market in the long run. The PPK System follows strict rules for buying and selling. You can learn more about this trading service by clicking here.