Do These 3 Graham’s Formula Stocks Satisfy Growth and Value?


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Jae Jun

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With the Ben Graham Formula Screen having achieved 20% in 2014,why not take a look at some more stocks to see if they meet Graham’s formula for growth and value.

The passing stocks here are based on Graham’s idea of simulating growth companies so it’s not the typical conservative measure that Graham would normally use.

This is the formula used to find the 3 stocks mentioned below.

Modified Graham Formula

Before I get into the companies…

Growth and Value are Joined at the Hip

When it comes to valuation, calculating intrinsic value involves both growth and value.

Here’s what Buffett said back in 1992.

But how, you will ask, does one decide what’s “attractive”? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. – 1992 Letter

A Quick Word on the Art of Valuation

Buffett wrote his letter much later than when the formula was originally crafted by Graham. But I use it exactly for the reason stated by Buffett – as the growth value component of the equation.

Intrinsic value = growth + tangible assets

Instead of locking myself into a zero growth valuation and getting tunnel vision, a growth based valuation is also required to get a much clearer view of the company and its future.

For no growth, I could easily get it from my EPV calculations which has zero growth value in the final number.

Yes. Growth is difficult to predict.

Ask all the AAPL analysts. 100% of them failed to get the latest quarter estimates correct.

But by zooming out and using different views, it gets easier to estimate the growth for valuation.

It’s why I advocate getting to know multiple valuation methods so that you can use the best stock valuation method for that particular situation.

See here for a deeper discussion on the true way to use the Graham Formula and Graham Number.

3 Stocks Priced Below the Graham’s Formula

Precautionary point:

  • consider the values that you see when using the Graham formula as the upper limit on the valuation range
  • for the EPS, I use either the normalized EPS or TTM EPS depending on my interpretation of the company stability and outlook

Arrow Electronics (ARW)

I used to work in the same office park as Arrow Electronics and never looked into what they did.

Based on this performance chart, investment opportunities can be right under your nose.

ARW vs Peers vs S&P

But moving on.

Looking over their catalog, the company sells electrical components like diodes, amplifiers and all the little stuff that go into electronic products.

Engineering services are also offered, as well as IT and computing solutions which came along with an acquisition in 2013 of ComputerLinks.

The Main Numbers

  • Current Price: $55.86 (at time of writing)
  • Normalized EPS of $5.16
  • Growth rate: 10%
  • Graham Formula Value: $79
  • Graham Number No Growth: $46

What’s to Like

There’s room to grow via acquisitions in fragmented and competitive industries.

Arrow Electronics isn’t the biggest name in the space, and so far, their acquisitions have been small. 3 small acquisitions were made in 2014 with cash and 4 in 2013.

The company also has a TTM Piotroski score of 7 which is an improvement from the 5 it received in 2013.

Return on Assets, Gross margins and asset turnover improved but quality of earnings fell.

Quality of Earnings is determined by checking that cash from operations exceeds net income. If cash from operations is consistently below net income, it’s a red flag.

What’s to Dislike

The obvious one is the competitive nature of the industry. Average net margins are thin at around 2.3% even after excluding 2008.

Very Thin Margins (Enlarge) | Source: Old School Value

Although it’s consistent, any one time event could turn profitability upside down, just like 2008.

And when you see a company with thin margins, it’s not surprising that it doesn’t have a moat.

One quick way I verify this is to check the Net Reproduction Cost of the business with it’s Earnings Power Value.

EPV is Less than Reproduction Cost

The last piece that I don’t like is the amount of working capital required as well as the inconsistent FCF.

You can see how much working capital a business needs by going through the cash flow statement, but a quicker way that I’ve found is to get the FCF number and compare it with the Owner Earnings calculation.

My version of owner earnings excludes changes in working capital, so it’s easy to identify a company that needs a lot.

Here’s what I mean.

FCF vs Owner Earnings Easily Shows Working Capital Requirements (Enlarge)

Those are some big differences.

And the message I get when I see this is that

  1. ARW needs a lot of money
  2. A downturn will really hurt the company as evidenced by the margins
  3. Will require debt in order to run such a business

Off my hunch on the third point above, it looks like the debt to equity is 52%. There isn’t any financial difficulty as it’s all long term debt with a good current ratio, but this is something to consider with the business.

Stepan Company (SCL)

Stepan is a manufacturer of specialty and intermediate chemicals used in a variety of applications and industries.

It ranges from cleaning and washing chemicals (detergents, shampoo, fabric softeners), to paints, cosmetics, food and a whole lot more.

According to Stepan, they say that they are

“…unique in the industry and do not have a competitor or competitors to precisely match its businesses because our products have a specific focus.”

But the company has 3 reportable segments

  1. Surfactants (cleaning chemicals)
  2. Polymers (used in plastics and other resins)
  3. Specialty Products (such as natural flavors in the food industry, oils and alternative fats)

The Graham Numbers

  • Current Price: $39.42
  • TTM EPS of $2.68
  • Growth rate: 8%
  • Graham Formula Value: $45.24
  • Graham Number No Growth: $38.81

What’s to Like

Consistent dividend payer with a decent balance sheet to counter the weak efficiency and margins.

The price has come down quite a bit from its 52 week high of $66 and there is a fair amount of pessimism. There are certainly headwinds going forward and management has grand plans which will require several years before results will be reflected.

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There was a tiny bit of insider buying at $52 and $43. Insider buying signals only one thing.

That the insider thinks the stock price is cheap. But with a high intrinsic value of $45, I wouldn’t want to buy above $33 anyways.

What’s to Dislike

Here’s one of the reasons why I don’t like to buy anything straight from a screen.

In a single year of holding the company according to the rules, the stock may do well, but as a long term hold, it’s not a keeper.

There are clearly more negatives here than positives.

Starting from the top, sales are slowing, gross margins are decreasing, and net margins are still thin.

These declines are easily seen in the ratios that I follow.

Declining Important Ratios | Enlarge

The total debt to equity ratio is 46% with 40% of it made up of long term debt. However, management has expressed that they want to leverage the balance sheet further to increase capex and expand more overseas.

This is just one of the slides from their presentation which I find to have a lot of optimism.

Stepan's Balance Sheet Leverage Plan

Stepan’s Balance Sheet Leverage Plan

The Andersons (ANDE)

The company has been around for over 70 years which started out as a single grain company and is now a diversified agricultural company.

It’s been punished since early September when it was trading at its historical peak of around $70. With the stock down about 30%, let’s see why it shows up on the Graham formula screen.

They have 6 operations which has helped them grow nicely over the past decade

  1. Grain
  2. Ethanol
  3. Plant Nutrients
  4. Rail
  5. Turf and Specialty
  6. Retail

Here’s a nice image from their website with more details about each group.

The 6 Groups of The Andersons

The 6 Groups of The Andersons

The Main Numbers

  • Current Price: $46.31
  • TTM EPS of $4.05
  • Growth rate: 8%
  • Graham Formula Value: $68
  • Graham Number No Growth: $51

What’s to Like

Agriculture and grain will always be needed. The majority of revenues comes from the grain group and makes up 65% of sales.

Ethanol is a distant second at 15%, plant nutrients at 12%, rail at 3%, turf and specialty at 2.5% and retail at 2.5%.

The median EPS CAGR over the past 5 years is actually 24.1% compared to 15.6% over the past 10 years.

These are fantastic numbers, but not to be relied on as the big EPS jump in 2010 were thanks to acquisitions. Despite this, at 8% growth, where analysts are expecting 11.2% growth, the current price is in attractive territory.

It’s hard to get high ratios for commodity businesses, but the numbers look good for the business it’s in.

Near 5 Year Lows | Enlarge

Near 5 Year Lows | Enlarge

What’s to Dislike

 To invest in The Andersons, you have to have a good understanding of 6 industries. Somewhat similar, but still different.

Outside of rails and retail, it’s also a commodity business which is reflected in low margins.But the consistency and ability to generate an ROE above 10% is impressive.

Unless you are confident in your ability to understand the futures market (particularly grain, ethanol and oil) The Andersons is a tough one to figure out an entry price.

I wouldn’t go as far as to say that The Andersons is a value destroyer, but Greenwald’s EPV model certainly doesn’t like the business.

The Andersons = No Moat

The Andersons = No Moat

Summing Up

That’s three stocks I picked out from the screen, but when looking deeper, they are not companies I would jump at the opportunity to buy.

From a valuation stand point, The Andersons is the best pick, but with a complex and commodity business, I’d rather pass for now.

I’ll continue to see whether I can get some better picks from the other value screens and let you know.

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