Price on Value
November, 2000

Selecting Stocks the Benjamin Graham Way

John Price,  Ph.D.

Benjamin Graham was a genius. When he graduated from Columbia College he was offered teaching positions in English, mathematics and philosophy. But as fate would have it, he started his career on Wall Street working for Newburger, Henderson and Loeb as a runner delivering checks and securities. His talent was soon recognized and within a few months he was writing one of its daily market letters.

His reputation as the father of value investing can be dated from 1928 when he started teaching a course Advanced Security Analysis at his old college. He had been thinking of writing a book and he reasoned that the best way to get this done was to start by preparing and teaching the material in a classroom setting.

The notes from the course were transcribed by David Dodd and formed the basis of the investment classic Security Analysis which was published in 1934.

Graham's classes were often attended by financial analysts who freely acted on the tips given by Graham. In fact, many admitted that his courses were so profitable that they attended them over consecutive years. His classes and the Graham and Dodd book were the foundation of a whole new approach to the investment industry based on principles that appealed to common-sense but were at the same time exceedingly effective. "Understand the difference between price and value" and "always allow for a margin of safety" are two examples.

One of Graham's early rules was the Net Current Asset Value NCAV approach described last month. He defined NCAV as the current assets of a company less all its liabilities. In his later years he sort other combinations of conditions that could be used by any investor to find attractive stocks. In the 1970s he described a set of ten criteria that, he declared, "seemed to be practically a foolproof way of getting good results out of common stock investments with a minimum of work."

The ten rules developed by Graham are to choose stocks with:
1. An earnings-to-price yield at least twice the AAA bond yield.
2. A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
3. A dividend yield of at least two-thirds the AAA bond yield.
4. Stock price below two-thirds of tangible book value per share.
5. Stock price two-thirds "net current asset value."
6. Total debt less than book value
7. Current ratio greater than two.
8. Total debt less than twice "net current asset value."
9. Earnings growth of prior ten years at least 7 percent on an annual basis.
10. Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.

The first five criteria were meant to determine "reward" and the second five "risk." I was interested to note that Benjamin Graham included "stability of growth of earnings" as one of the criteria. The degree of this stability is measured precisely by a function I developed for my investment software Valuesoft. (Click here for the article.)

In 1984 Henry Oppenheimer published a study of Graham's selection criteria in the Financial Analysts Journal. He used various groupings of the criteria to test which were the best at predicting superior performance over the period from 1974 to 1981. Amongst other results, he found that an investor who chose stocks using just criteria (1) and (6) would have achieved a mean annual return of 38 percent compared to a market return of just 14 percent. Use of criteria (3) and (6) would have given an annual return of 26 percent.

Oppenheimer also observed that the performance of Graham's criteria declined after 1976 but still outperformed basic benchmarks.

Just as with any other screening method based on simple criteria, results can be excellent in one period and limited in another. So blind application is never recommended. But as a starting point for finding quality stocks, Graham's ten criteria are well worth a second look.
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Warren Buffett and other leading investors always talk about buying stocks as if you were buying the whole company. But what about selling? In next month's article I will argue that in selling stocks you need something more than acting as if you were "selling the whole company."