For the past several weeks, we have been reviewing a variety of financial ratios any investor can use to find safer shares in troubled markets.  With the current uncertainty regarding the price of oil, these markets certainly qualify as troubled.

Financial ratio analysis is a critical tool in the investing strategy, Fundamental Analysis.  Legendary American investor, Benjamin Graham, is considered the father of fundamental analysis.  In his landmark book, -- “The Intelligent Investor” -- he describes seven tests conservative investors can use to evaluate defensive, or safer, shares.  Here are Graham’s tests:

Test #1:  Adequate Size of the Enterprise
Test #2:  Sufficiently Strong Financial Condition
Test #3:  Earnings Stability
Test #4:  Dividend Record
Test #5:  Earnings Growth
Test #6:  Moderate Price to Earnings Ratio
Test #7:  Moderate Ratio of Price to Assets

First, we are going to review briefly what Graham had to say about applying each of the tests.  Then we will see how some well-known Australian shares measure up as defensive or safer investments.

Adequate Size of the Enterprise

If you think of markets as global oceans and individual shares as boats operating on the ocean, it is easy to understand why large enterprises can withstand rough economic weather better than smaller enterprises.  When Graham wrote the Intelligent Investor back in 1970, the rough measure he provided was a minimum of $100 million in sales for an industrial enterprise and about $50 million in assets for public utilities.  Adjusting for inflation, the measures today would be around $465 million in sales for an industrial company and $230 million in assets for utilities.

Simply put, you find more safety in shares of larger companies.  Another legendary American investor, Peter Lynch, agrees.  In his book, One Up on Wall Street, he says –

“Big companies have small moves and small companies have big moves.”

Many retail investors new to the share market are intrigued with the smaller, high potential shares that have the potential for big moves.  The problem is those moves go both ways.  Larger enterprises typically show smaller price movements in either direction.

Sufficiently Strong Financial Condition

One of Graham’s star pupils, Warren Buffet, has said repeatedly, the first rule of investing is “Don’t lose money.”  There is no quicker way to lose money in the share market than to be invested in a company that defaults on its debt or ends up in bankruptcy.  

For Graham, the defensive move is to limit your investment targets to companies exhibiting a Current Ratio of at least 2.0, meaning the company has sufficient capital resources to pay its bills for the year two times over.  For every dollar in current liabilities, the company has $2 in current assets to cover the liabilities.

Long-term debt should never exceed working capital in an industrial concern and utilities’ long-term debt should not be greater than twice shareholder equity at book value.

Earnings Stability

With the exception of start-up and speculative shares, all investors are interested in earnings.  Safer shares are those where earnings do not vary wildly over time.  In Graham’s view, looking back at 10 years of earnings history and finding at least some positive earnings each year is a sign of earnings stability.  

Dividend Record

Many investors see dividend-paying shares as safe investments and Graham certainly agreed.  However, companies can and sometimes do reduce or eliminate their dividends in tough times.  Graham looked back a full 20 years to determine whether the company was able to pay a dividend consistently.  In his view, that kind of past performance was a good indication dividends would continue to be paid in the future.

Earnings Growth

Safer shares grow their earnings each year at a minimum keeping pace with the rate of inflation.  Growth less than inflation is in reality no growth at all.  His formula for measuring earnings growth is somewhat complex.  He took a 10-year period and looked for a minimum one third in per share earnings growth, using three-year averages at each end of the period.  Contemporary advocates of the fundamental approach to investing, such as Morningstar Australia, provide these measures in an understandable format.

Moderate Price to Earnings and Price to Asset Ratios

Graham was not as keen on the P/E ratio as many contemporary investors.  A P/E over 15 was an indication the shares were overpriced and subject to a fall during tough times.  He also shied away from shares where the share price was greater that one and a half times book value.

In recent weeks, turmoil in the Middle East has led to stormy investing seas that may get significantly rougher.  While rising oil prices have strong negative impact on much of our economy, they are good for energy company shares.  Check the price history of most energy stocks and you will see many reached all time highs when oil prices also reached all time highs in 2008.

How would some of Australia’s largest oil industry shares measure up against Benjamin Graham’s seven tests?  Courtesy of Morningstar Australia, we have some numbers for you from Oil Search Limited (OSH), Santos Limited (STO), and Woodside Petroleum Limited (WPL):

At first glance, it would appear none of the three measures up to Graham’s P/E test.  However, as you probably know, different industries often reflect higher P/E ratios across the board than market averages.  The average P/E for the ASX is 14.6 while for the Oil Industry Sector it is 25.1, well above the generally accepted norm of 15.  Using that measure as a comparison, only OSH would appear to be grossly overpriced, in the eyes of Graham while WPL is actually slightly underpriced.

However, WPL fails on the current ratio measure while all three shares exhibit solid earnings and dividend stability.  Recognizing the fact it is not a perfect world and in some cases, safe shares do not exactly fit each measure we apply, at this point it appears STO is the safest of the three.  

To dig a little further, let’s look at earnings growth for the three companies over the last 10 years.  Morningstar Australia does the complex math.  Here are the comparisons over a 10-year, 5-year, and 1-year period:

Although their 1-Year growth is dramatic, Santos does not meet Graham’s test for long-term consistent earnings growth.  In fact, none of these three Australian oil giants meets all seven tests.  However, even Graham himself might be driven to dig a bit deeper into these stocks.  For example, WPL’s current ratio and 1-year earnings growth might be explained by accounting artifacts, such as one-time charges.  The same could be said for OSH’s hefty P/E Ratio.  If you have other reasons to like the shares of any of these companies, digging into the accounting notes of their financial statements might provide some answers.