Kohl's Meets Ben Graham's Most Important Rules

By Will Ashworth | April 22, 2011 AAA

Value investors are likely familiar with Ben Graham's 10 criteria for selecting stocks. Graham came up with the list as a foolproof way to get good stock performance with very little effort. It was a stock screen before there were computers. Today, these rules are virtually impossible for most companies to meet. But, studies have shown that two rules stand out amongst the 10 criteria as necessary to outperform the indexes and Kohl's (NYSE:KSS) currently meets both.
TUTORIAL: How To Manage Credit And Debt

Rule #1
Graham's first rule is that a stock's earnings yield be twice that of the 10-Year AAA bond yield. The current 10-Year AAA bond yield is 3.4% meaning Kohl's needs an earnings-to-price yield of 6.8% or higher. Its current earnings yield is 7%, just qualifying in Graham's eyes. However, when compared to some of its peers, it does more than fine. Only Macy's has a higher earnings yield and its financial situation isn't nearly as strong. Kohl's cash position is higher than its total debt, whereas Macy's cash position is one-fifth its total debt. Of its peers listed in the table below, only TJX has a better cash position.

Kohl's and Peers

Company Earnings Yield Total Debt/Tangible Book Current Ratio
Kohl\'s (NYSE:KSS) 7.0% 0.26 2.08
Macy\'s (NYSE:M) 8.2% 6.17 1.36
TJX (NYSE:TJX) 6.3% 0.27 1.63
Sears Holdings (Nasdaq:SHLD) 1.4% 0.93 1.34
J.C. Penney (NYSE:JCP) 4.3% 0.56 2.41

Rule #6
Here we look for companies whose total debt is less than tangible book value. Tangible book value is total assets less intangible assets (like goodwill, patents and trademarks and all liabilities). For businesses like Kohl's, which doesn't posses any intangible assets, tangible book is the same as book value. For others, like Macy's, the difference is significant. Macy's book value is $5.5 billion while its tangible book is $4.4 billion. Only TJX comes close to matching Kohl's financial position.

The Other Rules
Of the remaining eight rules, most studies focus on the third rule, which calls for a dividend yield two-thirds the 10-Year AAA bond yield. Kohl's and Sear's Holdings don't pay dividends while its three other peers pay small ones. None of the companies meets the 4.5% required under Graham's system. Therefore, instead of using rule number three, I'll go with rule number seven, which calls for a current ratio greater than two. Here, only Kohl's and JC Penney meet Graham's criteria with the latter doing a slightly better job meeting its short-term obligations. As for the remaining seven criteria, all five companies have a tough time meeting the extremely high standards set by the creator of value investing.

Bottom Line
Kohl's has done a good job the past decade growing both top- and bottom-line numbers. In 2011, it will open 40 stores and remodel 100 and that's plenty. Given its strong financial condition, I believe its enterprise value should be higher than 5.8 times EBITDA, thus presenting a good buying opportunity. (Learn about the man who mentored Warren Buffett. Check out The Intelligent Investor: Benjamin Graham.)

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