"The Father of Value Investing" Graham: 10 Indicators for Stock Selection.

Graham's investment experience and philosophy.

When it comes to value investing, one cannot help but mention Benjamin Graham, who is recognized as the 'father of value investing.'

He is not only a master investor but also a professor and economist. He authored two classic works, 'Security Analysis' and 'The Intelligent Investor,' which have influenced many investors. Among them, 'Security Analysis' transformed the once-mysterious asset management activities into a modern profession, while 'The Intelligent Investor' is regarded as the bible of value investing.

Many investment masters were once Graham's disciples, including Warren Buffett and Irving Kahn. Buffett has said that Graham was not just an author or teacher; his impact on his life was second only to that of his father.

So what was Graham's investment experience like? After graduating with excellent grades from Columbia University, he worked on Wall Street. He transitioned from a clerk to an analyst, and eventually co-managed Graham-Newman Company, gradually growing into a master of stock research. Despite suffering great losses during the Great Depression from 1929 to 1932, the annualized return of Graham-Newman Company from 1936 until retirement in 1956 was no less than 14.7%.

In Graham's investment career, one notable case is the investment in 'Northern Pipe Company.' He believed that many of the bonds held by this company were not being utilized well, so he bought its stock, allied with other shareholders, demanded that the company redeem those bonds, and distribute dividends to shareholders, ultimately making a substantial profit.

There are many similar success cases because Graham had his own set of core principles. For instance, he focused on the intrinsic value of a business, believing that intrinsic value does not depend on stock prices. He felt that the market is always fluctuating, and savvy investors can take advantage of these fluctuations. He valued the margin of safety, expecting to 'buy an asset worth $50 for 1 cent.'

Graham's 10 stock selection criteria.

So how can we use Graham's core principles to guide our actual investments? The “Ten Standards” summarized by Graham in his later years provides a reference, let’s take a closer look.

1. Specific Standards

1) The earnings yield of the Stocks should be greater than twice the yield of US AAA rated Bonds.

What does this mean? Earnings yield = 1/PE = Net income/Total Market Cap. We can understand this as: if a company is bought out, the profit it generates in a year can yield this return.

Therefore, this Indicator reflects stock valuation on one hand, usually a low Indicator indicates overvaluation, while a high Indicator indicates undervaluation. On the other hand, it also reflects the potential return level of the stock to some extent. This Indicator is more applicable to companies with relatively stable earnings.

Data from August 2, 2023, shows that the real yield of US-Merrill Lynch AAA corporate bonds is 4.87%. According to this value, the requirement here is that the earnings yield of the Stocks should be greater than 9.74%.

2) The PE of the Stocks should be less than 40% of its highest PE in the past five years.

PE = Total Market Cap/Net income = Stock price/EPS. This is a widely used valuation metric and is also applicable to companies with relatively stable earnings.

The standard here is to ensure that the current PE ratio does not sit at a high position through vertical comparison.

3) The dividend yield of Stocks should be greater than 2/3 of the yield of US AAA rated Bonds.

The dividend yield of Stocks refers to how much dividend can be obtained per unit of stock, which is an important part of the total ROI and also reflects the company's profitability to some extent.

If the yield of US AAA rated Bonds is still calculated at 4.87%, then the requirement here is for the dividend yield of Stocks to reach 3.25%.

4) The stock price should be lower than 2/3 of the net value of tangible Assets per share.

Tangible Assets are easier to estimate compared to intangible Assets. The stock price has a certain discount relative to the net value of tangible Assets per share, which is Graham's requirement for valuation and also reflects an emphasis on safety margin.

5) The stock price should be below 2/3 of the net current Assets per share.

The net current Assets per share is an indicator created by Graham, calculated as (current Assets - total liabilities - preferred stock) / number of circulating shares.

The stock price has a certain discount relative to the net current assets per share, which also reflects the valuation requirements and the provision of a margin of safety.

6) Total liabilities must be less than the net value of tangible assets.

This essentially requires that total liabilities can be fully settled through the monetization of tangible assets, thereby avoiding risks such as bankruptcy and delisting.

7) The current ratio must be greater than 2.

Current Ratio = Current Assets / Current Liabilities. Current assets refer to assets that are expected to be liquidated within one year, while current liabilities are debts that need to be repaid within one year.

The current ratio is an important indicator of a company's short-term solvency. Generally speaking, without considering other factors, a higher current ratio indicates a stronger ability to pay short-term debts.

8) Total liabilities should be less than twice the net current assets.

The ratio of total liabilities to net current assets does not have a specific indicator, but requiring this ratio to be less than 2 is also a requirement for the company's short-term solvency.

9) The average annualized earnings growth rate over the past 10 years must be greater than 7%.

10) There cannot be more than 2 instances over the past 10 years where the earnings growth rate is less than -5%.

Finally, let's talk about these last two points together. Earnings growth rate (usually referring to Net income growth rate) = (current Net income - previous Net income) / previous Net income × 100%.

On one hand, there are requirements for the annualized growth rate, and on the other hand, there are limitations on the low value of the growth rate for each year. Overall, it measures the stability of earnings growth, which is a standard concerning growth.

2. Summary

These ten standards cover multiple dimensions including valuation, ROI (including dividend yield), stock price bubbles, solvency, and growth. It seems to align with what Graham emphasized about intrinsic value and margin of safety in the previous section.

However, after reviewing these ten standards, does anyone feel that they are "too stringent"? Yes, it is quite difficult to find a company that can simultaneously meet these conditions, with a high dividend yield, low debt, and an average annualized earnings growth rate exceeding 7% over 10 years, etc.

So can it be simplified? Among these ten standards, some measure returns more, while others measure risks more. Graham mentioned that at least one return standard and one risk standard must be met.

This sounds much more feasible. Henry Oppenheimer once created an investment portfolio by filtering companies from the New York Stock Exchange and the American Stock Exchange, selecting those with a "profit return rate greater than twice the yield of AAA Bonds, and total liabilities less than the net value of tangible assets," and measured this portfolio's performance from 1974 to 1981, resulting in an average annualized return of 38%.

How do we apply this strategy?

Now, let's look again at what insights this strategy can provide us and how we can apply it.

The most important thing is the idea of value and margin of safety: we can filter companies with investment value based on valuation, payout ratio, solvency, growth potential, etc., while comparing the stock price with its EPS net value and net current asset indicators to form a certain margin of safety.

Based on this idea, specific indicators can be chosen and adjusted. Below is an example for educational purposes only, not representing any investment advice. Everyone should consider their personal situation in actual investments and make decisions that align better with their risk tolerance.

1. Valuation: It is difficult during the screening phase to directly compare the current PE of stocks with their highest PE over the past five years (the second indicator), so we can first consider the first indicator. A profit return rate greater than 9.74% can roughly be rephrased as a PE less than 10.

2. Return: The payout ratio is a factor that many investors, especially conservative investors, consider when selecting stocks. Here we can directly use the quantitative standard of the third indicator, which is a dividend yield greater than 3.25%.

3. Solvency: The sixth to eighth indicators are all related to solvency, but the sixth and eighth are difficult to filter. We can directly use indicator seven to filter stocks with a current ratio greater than 2. The current ratio is also a commonly used stock screening indicator.

4. Growth: This involves the 9th and 10th Indicators. The 10th Indicator is hard to use directly in the preliminary screening, so we can start with the 9th Indicator. However, using the 'net income growth rate over the past 10 years' as a stock selection criterion is somewhat difficult, so we will simplify it to first filter for an annual net income growth rate of >7%. After this, we can conduct further screening from the stock pool obtained after the preliminary selection.

5. Margin of Safety: This involves the 4th and 5th Indicators, which are also difficult to achieve in the preliminary screening, but can be considered later.

What else can be done in practice?

Now we have 4 specific Algo Indicators, so let's take the US stock market as an example and use the Futubull Stock Screener feature to put it into practice.

A total of 26 stocks were initially screened (based on data from January 10, 2024), which is not particularly many. On this basis, further screening can be conducted.

For example, the standards mentioned earlier that could not be achieved during the preliminary screening stage (such as further requirements regarding net income growth rate, and the comparison of stock price and some asset value to reflect the margin of safety) can be researched in more detail for specific stocks at this step to determine whether they meet such standards.

*Note: The images displayed on the screen are for illustrative purposes only and do not constitute any investment advice or guarantee.

It is possible that after this research and screening, there will still be quite a few stocks left. Additional points of personal interest can be added, such as bullish industries, familiar companies, or other fundamental Indicators, etc.

Lastly, a reminder for everyone, the third and fourth parts of this article are just a practical exercise, intended for teaching purposes only, and do not constitute investment advice. The strategy explained today based on Graham does not guarantee the selection of stocks that will definitely make a profit, but it is hoped to provide some inspiration.