'Father of value investing' Benjamin Graham: Ten Stock Selection Criteria

Graham's Investment Experience and Philosophy

When it comes to value investing, one cannot overlook the contribution of Benjamin Graham, who is often regarded as the "father of value investing."

He was not only an well-known investor but also a renowned professor and economist. His two classic works, "Security Analysis" and "The Intelligent Investor," have influenced many investors over the years. "Security Analysis" promoted money management practices to become a modern profession with more transparency. On the other hand, "The Intelligent Investor" has become the bible of value investing.

Many other well-known investors, such as Warren Buffet and Irving Kahn, were once Graham's students. According to Buffet, Graham's influence on him was second only to his father.

So, what kind of investment experience did Graham have? After graduating from Columbia University with honors, he started working on Wall Street. From starting as a clerk and an analyst, he co-founded the Graham-Newman Corporation and dived into stock research. Although he suffered heavy losses during the Great Depression of 1929-1932, the Graham-Newman Corporation achieved an annualized return rate of no less than 14.7% from 1936 to 1956, the year he retired.

During Graham's investment career, one of his most significant achievements was investing in the Northern Pipeline Company. He identified that the company held bond and cash assets, which were not being utilized optimally, so he purchased its stock, teamed up with other shareholders to force a proxy vote to distribute the assets to shareholders, allowing them to make substantial profits.

Graham had his own set of core principles that enabled him to succeed. For instance, he valued the intrinsic value of a company, believing that it does not depend on its stock price. He recognized that the market is always fluctuating, and shrewd investors can leverage these fluctuations. Moreover, he emphasized the importance of having a margin of safety and expected to "buy assets worth $1 for 50 cents".

Graham's Ten Stock Selection Criteria

Then, what are Graham's core principles in stock selection?

1. Let's take a closer look at Benjamin Graham's stock selection criteria.

(1) An earnings-to-price yield at least twice the AAA bond yield.

What does this mean? Earnings Yield = 1 / P/E ratio = Net Profit / Total Market Value. In other words, you may understand it as the annual return yield brought by the company's earnings if we have bought the company at the price of the total market value.

This indicator reflects stock valuation, with low values indicating overvaluation and high values indicating undervaluation. It also reflects the potential returns that stocks may generate to some extent. This indicator is suitable for companies with relatively stable earnings.

As of August 2, 2023, the actual yield on AAA-rated corporate bonds in the United States from Bank of America Merrill Lynch was 4.87%. If we calculate based on this value, then the requirement here is that the earnings yield of stocks should be greater than 9.74%.

(2) A price-earnings ratio less than 40 per cent of the highest price-earnings ratio the stock had over the past five years.

The P/E Ratio = Total Market Value / Net Profit = Price Per Share / Earnings Per Share. This indicator is particularly useful for companies with relatively stable profitability.

The standard here is to compare the relative value of the same stock at different periods to ensure it is not at a high point.

(3) A dividend yield of at least two-thirds the AAA bond yield.

The dividend yield of a stock refers to the amount of dividend income that an investor can receive for each unit of stock they own. It's an important component of the total investment return rate, and it also reflects the profitability of the company to some extent.

If the yield on AAA-rated bonds in the United States is still calculated at 4.87%, the requirement for the dividend yield of stocks to reach should be at least 3.25%.

(4) Stock price below two-thirds of tangible book value per share.

Graham's standard requires that the stock price be lower than two-thirds of the company's net tangible assets per share. This ensures that investors have a margin of safety by buying stocks at a discount to the company's tangible assets, which are easier to estimate accurately than intangible assets like brand value or intellectual property.

(5) Stock price below two-thirds of "net current asset value."

Net Current Assets Per Share is an indicator by Graham, calculated as: (Current Assets - Total Liabilities - Preferred Stock) / Number of Shares Outstanding.

This standard requires the stock price to have a discount relative to the Net Current Assets per Share. This reflects the importance of having a margin of safety when making stock valuation.

(6) Total debt less than book value.

Graham's standard requires a company's total debt to be less than its net tangible assets, ensuring that the value of its tangible assets is sufficient to cover its debts and reduce risks such as bankruptcy and delisting.

(7) Current ratio greater than two.

The current ratio is a key indicator of a company's ability to pay off short-term debts. It compares current assets to current liabilities, with higher ratios indicating greater short-term debt-paying ability.

(8) Total debt less than twice "net current asset value."

The ratio of total debt to net current assets doesn't have a clear standard, but Graham's requirement is for this ratio to be less than 2. This standard emphasizes the importance of a company's short-term debt-paying ability.

(9) Earnings growth of prior 10 years at least at a 7 per cent annual (compound) rate.

(10) Stability of growth of earnings in that no more than two declines of 5 per cent or more in year-end earnings in the prior 10 years are permissible.

These two standards focus on a company's profit growth rate. The first requires an average annualized profit growth rate of over 7% in the past decade, while the second restricts negative growth rate to no more than two instances of less than 5% in the same period. These standards evaluate a company's profit growth stability and are important for long-term investors seeking growth opportunities.

2. Summary

Graham's ten standards cover various aspects of valuation, return rate (including dividend yield), stock price bubble, debt-paying ability, growth, and more. They appear consistent with his emphasis on intrinsic value and margin of safety.

However, these standards may seem excessively strict since it can be challenging to find a company that meets all of them. For instance, such a company would need to have a high dividend yield, low debt levels, and an average annualized profit growth rate exceeding 7% in the past decade.

One possible solution is to simplify the standards by focusing on both returns and risks. Graham suggests meeting at least one standard for return and one for risk. This simplification makes the standards more feasible to apply.

For example, a trader named Henry Oppenheimer created a successful investment portfolio by screening stocks from the New York and American Stock Exchanges based on criteria, including "profit return rates greater than twice the yield on AAA-rated bonds" and "total debt lower than net tangible assets."

What can we learn from the above criteria?

The key concepts in Graham's strategy are a stock's value and margin of safety. To identify companies worth investing in, investors might want to consider factors such as valuation indicators, dividend yield, solvency, and growth. Next, a company's stock price relative to tangible book value per share and net current asset value can provide a margin of safety. When selecting specific indicators, there is some flexibility.

It should be noted that the article is for educational purposes and practical exercises only, and does not represent investment advice. Graham's strategy discussed in this article does not guarantee profits from individual stocks, it can provide valuable insights for investors.