Benjamin Graham's Last Will: 10 Useful Rules for Stock Selection

Monday, Feb 13 2012 by
10
Benjamin Grahams Last Will 10 Useful Rules for Stock Selection

We've discussed in the past some of the more familiar value/bargain screening criteria that can be derived from Benjamin Graham's earlier work, e.g the NCAV and Enterprising Investor Screens.

What may be less known to you, though, is some quantitative work that Graham did towards just before his death (known as his "Last Will") with the help of a aeronautical engineeer James Rea, where he first identified the 10 best-performing stock selection criteria and then apparently distilled them into the 3 most important criteria.

Background

It seems that, upon reading an article that Graham had written for Barron's—“Renaissance of Value"— Rea forwarded some of his quantitative/screening research to Graham. This led to a three-year working relationship before Graham died, which culminated in two articles, one by Rea and one by Blustein (for Forbes) where they set out the findings of the research based on 50 years of back-testing as to the most effective value screening criteria for the US market.

Benjamin Graham's 10 Rules for Stock Selection

Here's the list that Graham came up with. The idea behind the rules is that the first five measure "reward" (by pinpointing a low price in relation to key operating results like earnings) and the second five "risk" (by measuring financial soundness and stability of earnings).

  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
  6. Total debt less than book value
  7. Current ratio great than 2
  8. Total debt less than 2 times Net Current Asset Value
  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 ten years are permissible.

Unfortunately, the issue with these criteria is that, if all 10 are used, the criteria are just too onerous and are unlikely to result in a meaningful number of picks, especially with changing market conditions and business practices over time. The question which Graham and Rea explored is whether certain criteria can be preferred over others?

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5 Comments on this Article show/hide all

AnonymousUser605348 26th Feb 1 of 5

A fascinating article. However, with regard to rule 7 "current ratio greater than 2"... the ratio of what exactly? Debt-to-Book? Book-to-Debt? Price-to-Book?

Further the "this source" hyperlink on line 2 of section titled "the magic 3" redirects to a Page Not Found.

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shipoffrogs 26th Feb 2 of 5
1

In reply to post #452268

Mario - the Current Ratio = Current assets / current liabilities.
So, here Current assets need to be at least double current liabilities. It's a test of the company's liquidity.

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Gromley 26th Feb 3 of 5
2

Hi Mario,

Thanks for asking a question this article - it's an old one far pre-dating my arrival at Stocko so I hadn't seen it before.

I can at least answer the question in you first paragraph - "current ratio" is an established investment ratio, measuring a company's ability to pay its debts and obligations as they become due.

It is defined as current assets / current liabilities.

Current assets are essential those assets that are expected to be converted in to cash in the next 12 months and current liabilities are those liabilities expected to be paid out in cash in the next 12 months.

So a current ratio of > 2 says that the company has twice the 'nearly cash' assets needed to fulfil its short term obligations. (As every ratio is, it's a simplification but a half decent one)

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AnonymousUser605348 27th Feb 4 of 5

In reply to post #452273

Much appreciated!

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AnonymousUser605348 27th Feb 5 of 5

In reply to post #452278

Thanks for the clarification, this was very helpful.

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