Testing Benjamin Graham's Investment Criteria

 |  Includes: AEO, AMN, CKP, FRX, KMT, RDC, RS
by: Market Folly

What would Benjamin Graham buy today?

We thought it would be interesting to try and figure out what Benjamin Graham himself would be buying in the current environment, but we quickly realized that there's not much that comes close to meeting his standards. If you're unfamiliar with Benjamin Graham (shame on you), then all you need to know is that he was a legendary investor who helped pioneer the ways of value investing, and that he taught Warren Buffett a lot of what he uses today. To become more familiar with Graham's investing methods, we highly suggest checking out his The Intelligent Investor. If you had to own one book about fundamental investing, this would most likely be it. Security Analysis is the second of Graham's must-read books, and another excellent resource. The book features the value investing philosophies of Graham and Dodd and a foreword by Warren Buffett. After you've finished reading, you'll be able to tackle balance sheets like no one else.

Very few stocks would pass Graham's original stringent requirements in the current environment and that, in and of itself, surprised us. (I guess everything isn't quite as 'cheap' as many people thought). However, to be fair, Graham's criteria are very strict, so we made some changes to establish these value-inspired criteria. We set up some scans using a combination of the following criteria:

  • P/E Ratio less than 10 for strict scans, and less than 15 for more lenient scans.
  • Book Value > 0.01 (Price to book ratio of 1.2 or less for strict scans, and 2 or less for more lenient)
  • Current Ratio > 1.5
  • Return on equity > 15%
  • EPS growth > 3% (5 years)
  • Dividend growth over 5 years
  • Low debt/equity ratio
  • Insider ownership

We fiddled with the criteria on numerous scans to generate more ideas, and in no particular order, we came up with the following:

  1. Ameron International (NYSE:AMN)
  2. American Eagle Outfitters (NYSE:AEO)
  3. Checkpoint Systems (NYSE:CKP)
  4. Rowan Companies (NYSE:RDC)
  5. Kennametal (NYSE:KMT)
  6. Reliance Steel (NYSE:RS)
  7. Forest Laboratories (NYSE:FRX)

Keep in mind that all of these companies are on the lists for different reasons. Some met the majority of the criteria, but others made the list because they kept appearing on multiple broader, or more lenient scans. Again, maybe things aren't as "cheap" as people have argued. A possible problem could be the fact that Graham emphasizes the P/E ratio, and we're in an environment where the 'E' part of the equation (earnings) keep falling. We've posted before about how earnings estimates were too high and that they need to come down.

We're not currently advocating a position in any of these names and do not currently hold any. We merely wanted some names to poke around and investigate. For what it's worth, Ameron was the most frequent return in all the different scans we did. Just thought we'd toss out ideas for people to investigate. After all, value investor Warren Buffett has said that its time to start buying American.

Also worth noting is the list that Jim Grant's Interest Rate Observer came out with back in December. Their Graham list included names such as Tiffany's (NYSE:TIF), Radio Shack (NYSE:RSH), Pfizer (NYSE:PFE), Cooper Industries Inc (CBE), Nucor Corp (NYSE:NUE), Cintas Corp (NASDAQ:CTAS), Archer Daniels Midland (NYSE:ADM), & Molex (NASDAQ:MOLX). So, research away.

I think the main point here is that Graham's criteria are so strict that it really would take a depression for ideas to pop up on the legitimate Graham scans. Instead, we've opted for a hybrid value scan combining criteria from Graham, Buffett, and Dodd to create a slightly more lenient scan to generate ideas to keep an eye on. If you find any names that can pass Graham's strict tests, do let us know. Otherwise, I guess we'll just have to wait for a depression.