Benjamin Graham is widely regarded to be the founder of modern value investing. His greatest student, Warren Buffett, attributes much of his success to Graham’s teachings. In this article, we will provide an in-depth look at stocks that Graham might have liked.
Though Graham believed that much research is necessary and that no stock screening methodology is perfect, he did give us some guidelines on how to perform initial screening techniques to limit the number of investments that should be researched further. The following is a list of the attributes he suggests investors look for first, and they just happen to make a wonderful initial screener for potential investments. All of these come directly from his masterful work, “The Intelligent Investor,” a book which Warren Buffett hails as “by far the best book on investing ever written.”
1. Price-to-book (P/B) ratio of less than 1.2.
Intangible assets such as intellectual property, brand name recognition, and customer base, are not reflected in the price-to-book ratio. Therefore, you could theoretically go for a P/B of less than 1.5, rather than 1.2 that Graham suggests. He recognized this fact as well and commented that the P/B could be up to 2.5 if the company has significant intangible assets. To maintain a margin of safety, however, we will look for a P/B of less than 1.2.
2. Earnings per share [EPS] should have grown by an average of 3% per year for the past 5 years
Accelerated EPS over a significant period of time is a sign of a solid business model, and of a capable management team. In this exercise, we go back 5 years, looking for 3%+ growth in earnings.
3. The price-to-earnings [P/E] ratio should be below 15.
Perhaps the most common valuation metric, the price-to-earnings ratio allows us to understand the earnings power of the company compared to its price. A high P/E ratio is common among “growth” stocks who are expecting phenomenal growth, but Graham believed that there is no way to be sure growth will continue at a pace that justifies the high price. While it is true that average P/E ratios vary from sector to sector, sticking with the low 15 benchmark will help maintain the safety-net that Graham believed to be crucial to minimizing risk.
4. The quick ratio should be above 1.5
In “The Intelligent Investor,” Graham suggests using a current ratio of above 1.5. The current ratio represents the current assets divided the current liabilities. This ensures that if the company faces a crisis, they have 50% more assets than liabilities to work with. Tweaking this criterion slightly, we are going to use the quick ratio instead, which is a more conservative number because it disregards any current assets that might be difficult to unload in a tight situation, such as inventory.
5. The company should pay out a dividend
Dividends, in Graham’s opinion, are a very important indicator of a company’s financial health. Not only that, but they indicate a shareholder friendly management team. For this screener, we locate stocks that pay out more than 2% annually.
The results from this screener are listed below, but are not the entire list of stocks who met the above criteria, but rather the ones we feel are the best based on our proprietary valuation methodology.