The Benjamin Graham Stock Screen – Investing Like the Godfather of Value Investing
Sequential stock screening involves reducing the universe of stocks to a manageable size. For example, sequential stock screening might involve reducing all US publicly-traded stock to 10 stocks for use in a portfolio by eliminating stocks, one by one, based on filtration criteria (usually with the most important criteria first.
Although there’s no absolutely best way to perform sequential stock screening, using criteria articulated by the famous Benjamin Graham is both a good way to approach stock screening and an excellent way to better understand some fundamentals that this man (and his successful investing successors) feel are important.
Benjamin Graham — Warren Buffet’s professor and mentor at Columbia University and author of such foundational books in investing as Security Analysis and The Intelligent Investor — had a stock-picking approach that fundamentally could be described as looking for deep value. He effectively advocated looking for those stocks that were pretty much sure bets but whose current prices were deeply undervalued. The main components of a Graham-style stock screen would consist of the following criteria when performing a stock screen.
Benjamin Graham – known as the godfather of value investing and the professor and mentor of Warren Buffett – advocated an approach to screening stocks that focused on stability and deep value.
Adequate size – avoid overly small companies
Adequate size can mean different things for different investors and there’s not a hard and fast rule that Graham articulated that we can apply in today’s market, but an investor can do one of two things in order to screen for size:
- create a market cap cut off: a simple market cap choice can be used where any firm that is below a certain market cap is filtered out (eg. any firm below a $25 billion market cap)
- clearly, with a hard market cap cut off, adjustment might be necessary over the years as the market and the economy moves
- percentile: a more nuanced approach where the bottom x-percent of the market can be cut off (eg. the bottom 50% of the market in terms of market cap)
- this approach leads to less adjustment because using a percentile will automatically adjust the cut off as the overall market changes and shifts based on growth and the business cycle
Sufficiently strong financial conditions
This is another slightly ambiguous criterion and can be interpreted in different ways – it can mean having enough cash or not having too much debt (eg. various leverage-related metrics). Things to look at can be:
- cash position
- quick ratio
- current ratio
- leverage ratio
Uninterrupted dividend payments for the last 20 years
This is the heart of Graham-style investing – you’re focusing on a company that has done well over a very long period of time in the investing world. This would remove:
- most growth companies – they usually don’t pay dividends or are even racking up losses
- IPOs – they haven’t been around nearly long enough to actually have a track record
- companies that have hit hard times in terms of profit – you clearly want companies that have hit hard times in terms of valuation (eg. stock price), BUT you don’t want companies who have hit hard times in terms of revenue and profit in Graham-style investing
No losses for the last seven years
This is similar to the dividend requirement – it shows that the firm has been doing well for a significant period of time. Not having losses for the past 7 years (or however many years you might choose – 5 years, 10 years, etc.) will provide some sort of assurance over the quality, resiliency, and robustness of the businesses the firm is in.
As above, this filter will rule out companies where you can’t actually observe profits or losses for the last 7 years or companies that haven’t existed for at least 7 years.
Increase in per-share earning of a least 33% in the past 10 years
As with the above, this shows long-term stability of the firm’s business model – you want to see that the business is at least keeping up with (or beating) inflation in terms of its profits.
Current price no more than one and a half times book value
This is a deep-value filter – we’re looking for first that that are trading at only 1.5x book value. Book value can be thought of as liquidation value – book value is different from the market value in that it literally show the value on the “books” of the firm. This filter tells us that we want to buy firms whose market value is only 1.5x the firm’s book value – this usually means the firm is reasonably valued.
To compare the 1.5x market to book value we’re looking at here and to better understand it in the context of the overall market, let’s look at the market to book value of the S&P 500. As of late 2016, the price to book of the S&P 500 was right around 3x, meaning the overall S&P 500 was trading at a price three times higher than the combined book value of all firms that comprise the S&P 500. Near the Dot Com Bubble the price to book of the S&P was about 5x.
Current price should not exceed 15 times average earnings of the past three years (P/E ratio < 15)
This is a simple price to earnings (P/E) filter to make sure the firm isn’t overvalued in terms of the P/E multiple. A P/E ratio of 15 is not considered very low but more of a moderate P/E ratio – a more conservative investor can adjust this easily to a trailing 3 year P/E of 12 (or even 10). A more aggressive investor or an investor operating in a generally deeply overvalued market who is still looking to park his money in equities might adjust this P/E ratio up to 17 (or even 20) in order to not eliminate so many stocks from the filter. However, as you move the P/E ratio up, you’re getting away from the Graham-style conservative approach and moving towards as you allow potentially reasonably valued (as opposed to undervalued) equities into the mix.
Current assets worth at least one and a half times current liabilities
This is a classic leverage filter where you look at whether your current assets are sufficient to provide current liability coverage if necessary. The world “current” in finance (for both assets and liabilities) generally means that one year or less – so current liabilities are liabilities (eg. debts) that can reasonably be expected to need to be repaid within one year.
This filter prevents a very unpleasant situation where an otherwise profitable firm might possibly be forced to liquidate productive assets or be forced into bankruptcy due to an inability to cover short-term debts due to adverse economic conditions or a change in the business cycle.
It’s important to note, however, that not all fo the above criteria have to be used – Benjamin Graham didn’t articulate a particular sequential screening strategy but instead articulated principles that are represented in the above filters