A great way to find ideas is to use the selection checklist of gurus. There is one by Benjamin Graham that not too many people know about. A couple of readers have been kind enough to provide the selection criteria and papers testing the process which I will go into detail here.
Graham’s Stock Selection Criteria
- Forum link to the discussion of Graham’s stock selection criteria.
- Test of Graham’s stock selection criteria on industrial shares traded on the JSE (pdf)
There are 10 criteria in total.
The first 5 criteria measure ‘reward’ and is sensitive to price and earnings changes. The focus in this group of five criteria is on stock price, earnings and dividends.
The second group of 5 offers a measure of ‘risk’ and does not change rapidly with changes in price and earnings. Criteria number 6,7 and 8 represent the financial soundness of companies.
Selection, by using the criteria, is based on the concept of maximising the ‘reward’ to ‘risk’ ratio of stock selected.
One thing I want to point out is that the reward-risk philosophy is backward. Personally, after chasing reward to risk much often and taking the damage, I have found it much better to chase after low risk to reward ratios. It may sound like the same thing, but determining low risk followed by reward is much different to finding reward and then performing the risk analysis.
List of 10 Stock Selection Criteria by Benjamin Graham
1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value (NCAV)
6. Total debt less than book value
7. Current ratio great than 2
8. Total debt less than 2 times Net Current Asset Value (NCAV)
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible.
Test Combination of Criteria
Not a single stock will be able to pass this filter today. When the screen reaches no. 3, only around 30 stocks make it. When you hit the fourth condition, the list becomes 0.
So to make this exercise worthwhile, I would have to run the criteria in combination with each other but not all at the same time.
The table below is from the paper with the test performed from 1977 to 1995, a span of 18 years.
Keep in mind that back in the days of Graham, most companies were industrial and the stock universe was much smaller then as well.
In order to clean up the results, I left out financial stocks, OTC stocks and ADR’s.
I do not have access to historical AAA bond yield data so I applied a static 4.5% as the AAA bond yield for all screens for all periods.
Still, it results in plenty of pickings. The additional condition that I applied was (7) Current ratio great than 2.
I also tested one that included (8) Total debt less than 2 times Net Current Asset Value (NCAV). The number of results were reduced but the screen did not perform any better so I left it out.
Graham Stock Selection Criteria Results
With the limited amount of data that I have access to, 20 years of back testing is out of the question. 20 year tests also do not serve much purpose. Such tests, I find to be distorted due to it being unrealistic. You might as well do the test for 100 years and conclude it kills the market.
I chose the period from 2004 end of August 2010 to test the results.
I didn’t want to apply the test in 2001-2003 because of the dot com bust. By 2004, the recession was over, markets have stabilized and “ordinary” people would have gotten back into the market. Not quite Nobel prize worthy, but realistic.
The conditions I applied to all screens are as follows:
- ignore financial companies, OTC and ADR’s
- AAA bond yield was kept at 4.5%
- max 20 stocks held
- 1 year holding period
I would say a 6 year period is long enough to say that this strategy would beat the indexes over the long run. With $100, the screen depicted by the orange line would have netted $193.
Individual year performance will vary and fluctuate and you won’t beat the market every year, but Graham’s simple selections looks to be solid for the passive investor as well as being a good source of ideas for the enterprising.
10 Stocks that Graham Would Choose
Applying the (1),(3),(6) & (7) conditions, here is a list of stocks that even Graham would be interested in if he were alive.