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Summary Ben Graham’s stock selection criteria are tried and true for the defensive investor. Public utilities, represented by the Dow Jones Utility Average (DJUA), are no longer sound investments for the defensive investor today. Great variations are found among the 15 DJUA components, allowing an enterprising investor to select stocks higher in both quality and quantity than the average. In a previous article , we revisited Benjamin Graham’s stock selection criteria, applied them to the thirty issues in the Dow Jones Industrial Average (DJIA), and found the DJIA unsatisfactory, mostly failing the valuation criteria. Below are Graham’s 7 stock selection criteria for the defensive investor: Quality 1. Adequate Size of the Enterprise . Graham suggested at least $100 million of annual sales for an industrial company, and at least $50 million of assets for a public utility. These 1973 figures can be adjusted for inflation to roughly $500 million of annual sales and $250 million of assets today (2014). Market capitalization, used by many as a proxy for size, confuses market valuation with business fundamentals. While the two are very much correlated, they may widely diverge at times, and paying exorbitant price for a small business is the exact opposite of defensive investing. 2. A Sufficiently Strong Financial Condition . Current ratio should be at least 2:1 for industrial companies; debt to equity should be no more than 2:1 for public utilities. 3. Earnings Stability . Some earnings in each of past ten years. 4. Dividend Record . Uninterrupted payments for at least the past 20 years. 5. Earnings Growth . A minimum of at least one-third in per-share earnings in the past ten years using three year averages at the beginning and the end. Multi-year average earnings smooth out cyclical earning variations and better reflect a company’s true earning potential. This corresponds to 2.9% compound annual growth, a relatively low hurdle. Quantity 6. Moderate Price/Earnings Ratio . Current price should be no more than 15 times average earnings of the past three years. Again, ignore single year earnings. P/E calculated using trailing twelve month earnings or predicted earnings for the next 12 months are unreliable. 7. Moderate Ratio of Price to Assets . Current price should be no more than 1.5 times the book value last reported. Alternatively, the product of P/E and P/B should not exceed 22.5. A stock meeting this alternative criteria may be considered as fulfilling both quantity criteria and admitted for investment. Application of Graham’s Criteria to the DJUA in 2014 We will now turn our attention to the public utilities, specifically the 15 prominent issues in the Dow Jones Utility Average (DJUA), to see how many, if any, meet these stringent criteria for the defensive investor. As a frame of reference, when Graham did his analysis for the DJUA in 1971, he found all fifteen issues meeting the criteria. In his own words: In comparison with prominent industrial companies as represented by the DJIA, [the DJUA] offered almost as good a record of past growth, plus smaller fluctuations in the annual figures–both at a lower price in relation to earnings and assets. Can the same be said regarding the DJUA today? The table below lists the 15 DJUA stocks with the Graham criteria (red means it failed; green means it passed). These data are obtainable from SEC filings here . Stock Ticker Price Assets Debt/equity Earnings stability? Yrs of Uninterrupted Dividends 2002-2004 Avg Earnings 2011-2013 Avg Earnings Earnings Growth Price to Earnings Book value Price to Book (P/E)*(P/B) # Criteria Met Duke Energy DUK 80.62 119656 1.00 Yes 29 0.43 3.55 725.58% 22.71 58.57 1.38 31.26 6 Exelon EXC 35.48 85264 0.95 Yes 34 2.13 2.39 12.21% 14.85 27.45 1.29 19.19 6 Southern SO 47.76 67654 1.19 Yes 32 1.98 2.36 19.19% 20.24 22.07 2.16 43.79 4 American Electric Power AEP 57.83 57925 1.15 Yes 44 0.49 3.22 557.14% 17.96 34.48 1.68 30.12 5 PG&E PCG 51.94 57884 0.93 Yes 10 3.11 1.95 -37.30% 26.64 33.25 1.56 41.61 3 NextEra Energy NEE 101.08 53383 1.54 Yes 31 0.05 4.54 8980.00% 22.26 43.10 2.35 52.22 5 Dominion Resources D 71.79 52279 2.15 Yes 30 3.20 2.69 -15.94% 26.69 19.82 3.62 96.67 3 FirstEnergy FE 37.19 51224 1.70 Yes 16 1.98 1.66 -16.16% 22.40 30.19 1.23 27.60 4 Edison International EIX 63.18 49475 1.14 No 11 2.85 0.70 -75.44% 90.26 32.95 1.92 173.06 2 Consolidated Edison ED 64.14 40667 0.99 Yes 44 2.59 3.68 42.08% 17.43 43.39 1.48 25.76 6 AES AES 12.79 38983 2.76 No 2 (2.23) (0.33) NM NM 6.14 2.08 NM 1 Public Service Enterprise PEG 40.46 34147 0.74 Yes 107 1.09 2.62 140.37% 15.44 23.89 1.69 26.15 5 NiSource NI 39.10 23710 1.62 Yes 28 1.24 1.37 10.48% 28.54 19.04 2.05 58.61 4 CenterPoint Energy CNP 21.71 22048 1.92 No 44 (4.70) 1.62 NM 13.40 10.41 2.09 27.95 4 Amertican Water Works AWK 51.42 15716 1.20 No 6 1.10 1.94 76.36% 26.51 27.44 1.87 49.67 3 DJUA 51334 1.40 Yes 31 19.19% 26.09 1.90 50.26 4 Unfortunately, the DJUA has changed for the worse since 1971. Not even one of the 15 issues meet all 7 criteria today. It is poorer in both quality and quantity compared to 1971, when utility stocks were inviting to the defensive investor. Salient Aspects of the DJUA Today 1. Size is adequate , with all fifteen issues easily surpassing the minimum $250 million of assets stipulated. 2. Financial condition is adequate in the aggregate, with an average debt to equity ratio of 1.4 for the DJUA, and 13 out of 15 issues meeting the criteria of debt to equity less than 2:1. 3. Earning stability is satisfactory in the aggregate , but 4 out of these 15 issues failed this criteria, a worse showing compared to the DJIA, where only 1 out of 30 issues failed. This is both surprising and alarming, suggesting that utilities are no longer as stable or defensive as they once were. 4. Most of the issues have at least 20 year history of uninterrupted dividends , with an average of 31 for the DJUA. Although satisfactory, the dividend history for the DJUA pales compared to the DJIA, which boasts an average of 67 years of uninterrupted dividends. 5. Earnings growth is very poor . The median earnings for the DJUA is only 19% over the past decade, or 1.77% compounded annually, which does not even keep up with inflation. Only 6, or fewer than half, out of 15 issues met the threshold of at least one-third of per-share earnings over ten years. 6. Ratio of price to three-year average earnings was 26.31 for the DJUA today, which is 75% greater than the maximum 15 required. The DJUA today is not only significantly more amply valued compared to its past, but even more overvalued than the DJIA today, which has a ratio of price to three-year average earnings around 20. 7. Ratio of price to net asset value was 1.91 for the DJUA today, which is 27% greater than the maximum 1.5 required. This is significantly more expensive compared to a ratio of 1.21 for the DJUA in 1971, but more favorable compared to the corresponding figure of 4.38 for the DJIA today. That DJIA commands a higher price relative to asset than the DJUA is by no means surprising, since the industrials tend to have more intangible assets such as brand name, patents, franchises, and trade secrets, which we generally do not find in public utilities. Not all 15 DJUA Issues Are Created Equal It is important to note that although none of the 15 DJUA issues met criteria, significant variations in quality and quantity are detected among the issues. Duke Energy, American Electric Power, NextEra Energy, Consolidated Edison, and Public Service Enterprise Group are five high quality issues meeting all five quality criteria, but failing one or both of the quantity criteria. These would be good stocks to buy after a correction. Stock Ticker Price D/E P/E Book value P/B (P/E)*(P/B) ROE Yield Duke Energy DUK 80.62 1.00 22.71 58.57 1.38 31.26 6.06% 3.94% American Electric Power AEP 57.83 1.15 14.96 34.48 1.68 25.09 11.21% 3.67% NextEra Energy NEE 101.08 1.54 22.26 43.10 2.35 52.21 10.54% 2.87% Consolidated Edison ED 64.14 0.99 17.43 43.39 1.48 25.77 8.48% 3.93% Public Service Enterprise PEG 40.46 0.74 15.44 23.89 1.69 26.15 10.97% 3.66% Average 1.08 18.56 40.69 1.71 32.09 9.45% 3.61% Interestingly, despite these five issues possessing better quality than the composite DJUA, they sell at lower prices relative to earnings and assets compared to the DJUA, with P/E only 71% and P/B only 90% of the composite index. Debt to equity is only 1.08, which is only 77% of the DJUA. Enterprising investors do not have to “pay up” for quality in this peculiar case, and can obtain higher quality utility stocks with lower risk at better prices relative to earnings and assets. Return on equity for this group is 9.45%, not bad given the regulatory environment of public utilities. Exelon also stands out, meeting both quantity criteria and 4 out of 5 quality criteria, failing only the earning growth criterion. The enterprising investor may considering buying if he deems the recent low earnings temporary and trusts the company to turn around eventually, while getting paid a 3.5% dividend to wait it out. On the other hand, AES is demonstrably an inferior issue compared to the average DJUA stock. It has significantly higher debt, multiple years of earnings deficits within the past decade, but nevertheless selling at higher price in relation to its net asset value. Edison International and American Water Works are also inferior issues to be avoided for similar reasons. Conclusion As we have seen, utility stocks, as represented by the DJUA, are unattractive investment options for the defensive investor today. Compared to 1971, utility companies have become somewhat more aggressive, but in vain, evidenced by poorer ten year earnings growth. The moat once enjoyed by regulated public utilities appears to have eroded. Despite the poor showing, the market amply values utility stocks today, much more so compared to 1971, and, in terms of price in relation to earnings. even more so than the DJIA today. This overvaluation is likely the result of the multi-decade low interest rate environment we are in today, since public utilities, with their higher dividend yields and generally higher debt on the balance sheet, are more bond-like compared to industrial issues. At the current extremely low levels, interest rate have nowhere to go but up, which will not hurt bonds, as I wrote in a previous article , but also bond-like investments like public utilities. The defensive investor is well advised to avoid the DJUA for now and wait for a more favorable entry point when interest rates revert to the mean. 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