Benjamin Graham created two sets of stock selection criteria. One set which is more conservative for the defensive investor and another set for the enterprising investor, who is willing to take a higher risk with less stringent stock selection criteria. I will explore the stock selection criteria for the defensive investor in this article.
#1 Adequate Size of the Enterprise
Although small cap stocks can yield very high returns, Graham does not think it is suited for the defensive investor as the risk of losing money can be equally high. Hence, he has a rule of thumb to limit the size of the company for investment,
“…not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.”
#2 A Sufficiently Strong Financial Condition
The way to evaluate financial condition of a company is to look at the Debt-to-Asset or Debt-to-Equity ratios.
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Current ratio = 2, Or essentially, current assets are two times the current liabilities. “Current” means less than a year. Current Assets are assets that could be liquidated within a year while Current Liabilities are debts that are due in a year.
For utility companies, debt-to-equity ratio should not be more than 200%. This means that Total Liabilities should not be more than 2 times the Shareholders’ Equity. Shareholder’s equity is equivalent to Net Book Value and Net Asset Value (Total Assets minus Total Liabilities).
#3 Earnings Stability
Graham did not have a strict criteria for earnings. He just stated that the company should be making money every year, for the past 10 years.
#4 Dividend Record
I found Graham’s dividend criteria too stringent. He said that the company should be paying out dividends for the past 20 years. This criterion alone could eliminate many stocks.
#5 Earnings Growth
Graham’s criteria for earnings growth is less stringent than what most investors would use. While most investors want to see earnings growth from year to year, Graham believes that an increase of at least one-third in per-share earnings in the past ten years would be sufficient. Specifically, the average earnings between year 7 to 10 should be at least three times the average earnings between year 1 to 3.
#6 Moderate Price/Earnings Ratio
Price/Earnings Ratio or commonly known as PE Ratio, should be below 15. Specifically, current prices should not be more than 15 times the average of past 3 years’ earnings.
#7 Moderate Ratio of Price to Assets
Price-to-Net Asset Value or Price-to-Book Value (PB ratio) should be less than 1.5. Alternatively, the multiplication of PE and PB ratios should be less than 22.5. The number is derived from the multiplication of 15 (PE) and 1.5 (PB). Hence, if a stock has a PE value of 10, it is acceptable for PB to be as high as 2.25. In other words, a low PE can compensate a high PB, and vice versa.
These criteria were discussed in Benjamin Graham’s book, The Intelligenet Investor.