A Stock-Picker's Guide To Benjamin Graham's Screening Rules

This article is the first in a series about screens designed by famous investors. For an overview of the subject, see my previous article, Can Screening for Stocks Still Generate Alpha?

Benjamin Graham, who has often been called the father of value investing, published The Intelligent Investor in 1949 and revised it several times, most recently in 1972. In that last and fourth edition, published in 1973, he included three different sets of guidelines, which could be called “checklists” or “screens.” The first was for the “defensive investor,” and it’s the most famous. The second was a rule for investing in “Net-Current-Asset (or ‘Bargain’) Issues.” And the third was for the “enterprising investor.”

I’m going to take a close look at all three screens, re-creating them in Portfolio123; in addition, I’ll be offering some modifications to the first of those screens to bring it more up-to-date.

Part One: Stock Selection for the Defensive Investor

Graham lists seven selection criteria for the defensive investor. I’ve tried to duplicate them for today’s stocks (you can see my screening rules here). They are:

  1. Adequate Size of the Enterprise. Graham’s limit is $100 million in annual sales for most stocks and $50 million in assets for utilities. Now these are 1972 numbers. To get the current equivalent, I used a time series of the nominal GNP. So for right now, you’d need a minimum of $1.76 billion in sales or, for utilities, a minimum of $880 million in assets. Twenty years ago you’d need a minimum of $835 million in sales. Graham did not specify a minimum price per share, and if you were using his screen back in 2002, you’d have considered buying shares in Enron after they’d fallen to $0.35. I think setting a minimum per-share price of $1 makes sense here.
  2. A Sufficiently Strong Financial Condition. Graham specifies that current assets should be at least twice current liabilities, and long-term debt should not exceed net current assets (working capital). He makes an exception for utilities, saying they do not have to meet the first criteria, and for the second that their total debt should not exceed twice their book value (whenever Graham talks about book value, he means tangible book value). Unfortunately, these conditions do not apply to companies in the financial sector, which usually do not report current assets or current liabilities in their financial statements. Graham by no means thought that investors should exclude these companies: he is quite explicit on that score. Instead, he says, quite vaguely, that “The question of financial soundness is, therefore, more relevant here than in the case of the typical manufacturing or commercial enterprise.” So it’s up to each investor to make his or her own rules about this. For the purposes of this screen, I decided that companies in the financial sector should be in the top 20% of their respective industries in terms of their tangible common equity ratio and solvency ratio.
  3. Earnings Stability. Graham requires some positive earnings for each of the past ten years.
  4. Dividend Record. Graham requires uninterrupted dividend payments for each of the past twenty years.
  5. Earnings Growth. Graham specifies that the average earnings over the last three years should be 1/3 greater than the same number ten years ago.
  6. Moderate Price-to-Earnings Ratio. Again using the average earnings over the last three years, Graham specifies a maximum P/E of 15.
  7. Moderate Ratio of Price to Assets. Ideally, the ratio of price to tangible book value should be 1.5 or lower, but Graham allows this to be higher for stocks with very low P/E by applying the following rule: the stock’s P/E and P/B, when multiplied together, should be less than 22.5.

Not many stocks pass this screen. As of today (7/27/2020), only three non-ADRs pass: Credicorp (BAP), Cincinnati Financial (CINF), and Nucor (NUE). If you include ADRs (and Graham would likely have seen no good reason not to—he didn’t mention ADRs in his book, but there were plenty of them around when he was writing), the field expands considerably; but the data is, I’m afraid, less reliable.

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