by Henry R.

Oppenheimer

A Test

of Den Graham's Stock Selection Criteria

Benjamin Graham believed in the overall efficiency of securities markets, but he also believed that any conscientious investor could map a high trail through the slough of market efficiency by paying close attention to investment fundamentals and taking advantage of undervaluation and mispricing of individual securities. Among the maps he bequeathed to investors was a list of 10 criteriafor identifying undervalued stocks. The author screened New Yorkand AmericanStock Exchangesecurities to select those issues that met various sets of Graham'scriteriaand measured performances of portfolios formed from those issues over the years 1974 through 1981. Over that securities provided a mean annual return period, the CRSPindex of NYSE-AMEX (including dividends) of 14 per cent. An investor who had used Graham's advice to select from the NYSE-AMEXuniverse securities of firms with an earnings-toprice ratio at least twice the AAA bond yield and total debt less than book value would have achieved a mean annual return of 38 per cent! Although the superior performance of the portfolios created from Graham's selection criteriadeclined after 1976, the year the criteriawere published, it did not disappear. Furthermore, excess returns remained after risk adjustment and adjustment for firm size effects.
"I can assure the reader that among the 500odd NYSE issues selling below seven times earnings today, there are plenty to be found for which the prices are not 'correct'ones, in any meaningful sense of the term. They are clearly worth more than current selling prices, and any security analyst worth his salt should be able to make up an attractiveportfolio out of this 'universe.' "'
T

lieved, further, that investors' emotional swings could cause "central values" to depart significantly from security prices. And he listed, in an article published in Forbes shortly after his death, the criteriainvestors could use to locate such inefficiencies.2 This article examines the efficacyof those criteria.3 The Study Table I lists Graham's 10 criteria. Graham and Rea suggested that the first five measure "reward" and the second five "risk."To be eligible for a portfolio, a security must meet at least one reward criterionand one risk criterion. Graham predicatedhis advice on the belief that a security's value and subsequent performancedepend on acceptableoperating performanceand a solid (conservative)financial condition. To test the criteria,I used a naive strategy that assumed an investor purchased securities

HUS BENJAMINGRAHAM argued in

the pages of this journal in 1974 that, while markets were efficient overall, pockets of inefficiencyexisted. He believed that opportunities for mispricing where most likely in the smaller, less analyzed issues. He be1. Footnotes appear at end of article

at the Professor of Finance HenryOppenheimer is Assistant of TexasChristian UniverM. J.NeeleySchool of Business sity.

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 D 68

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Table II Number of FirmsMeeting SpecificScreens

(1) & (6) (3) & (6) (1), (3) & (6) (1), (6) & (9) (1), (3), (6) & (9)

Criteria ScreenDate 12/31 1973 1974 1975 1976 1977 1978 1979
1980

NYSE

AMEX

NYSE

AMEX

NYSE

AMEX

NYSE

AMEX

NYSE

AMEX

113 183 54 45' 53 61 33

2

123 124 83 67 58 42 15
3

128 172 101 59 96 82 38

9

66 93 60 37 36 28 11
5

78 117 17 10 17 29 9
0

48 64 25 15 11 10 2
0

21 49 18 10 16 23 20

28 34 26 17 25 21 12
---

11 24 5 1 4 9 4

5 14 7 4 6 6 2

Table I BenjaminGraham'sStock Selection Criteria (1) An earnings-to-price yield at least twice the AAA bond yield. (2) A price-earningsratio less than 40 per cent of the highest price-earningsratio the stock had over the past five years. (3) A dividend yield of at least two-thirds the AAA bond yield. (4) Stock price below two-thirds of tangible book value per share. (5) Stock price below two-thirds "net currentasset value." (6) Totaldebt less than book value. (7) Currentratio greaterthan two. (8) Totaldebt less than twice "net currentasset value." (9) Earningsgrowth of prior 10 years at least at a 7 per cent annual (compound) rate. (10) Stabilityof growth of earnings in that no more than two declines of 5 per cent or more in year-end earnings in the prior 10 years are permissible.
Source: P. Blustein, "Ben Graham's Last Will and Testament,"
Forbes, August 1, 1977, pp. 43-45.

Each security was held, according to Graham's advice, for either two years or until 50 per cent price appreciation occurred-whichever came first. The performancesof the portfolios were evaluated using standardmethods. I used the CRSP tapes to obtain mean monthly returns for the securities and the market. I also calculatedriskadjusted returns, as follows:
Rit - Rft = ai + i (Rmt
-

Rft) + eit'

where:
Rit = the month t (t = 1,
. . ,

24) return

earned by a security meeting the screening criteria and purchased in month 0; Rft = the "risk-free" (Treasury bill) rate of return in month t;
Rmt = the rate of return on the market portfo-

simultaneously meeting two or more criteria. Initial tests were run separately on criteria (1) and (6), (3) and (6) and (1), (3) and (6).4 I assumed that the naive investor limited himself to securities traded on an organized exchange. The Compusat Industrial and Research tapes were screened for all New YorkStock Exchange (NYSE)and American Stock Exchange (AMEX) securities meeting any of the three sets of criteria on December 31 of each year between 1973 and 1980. Table II lists the number of securities on each exchange that qualified. Foreach screen of each exchange, I selected at random 35 securities (when possible) in proportion to their appearance in portfolios of eligible securities.5Equallyweighted portfolios of these securities were purchased on the last business day of March in the year following the screen.

lio (the CRSPvalue-weighted portfolio of NYSE and AMEXstocks);

,8i = cov(Rit, Rmt)I&o(Rmt),or security i's risk

relative to the market portfolio;

eit
=

an error term assumed to have expect-

ed value of zero and to be serially uncorrelated;and ai = a measure of monthly abnormal performance for the security evaluated. The equation merely says that realized security return in excess of the risk-free rate is a linear function of three terms-a premium for bearing risk (namely, the product of a security'srisk and the market's return in excess of the risk-free rate), a random error term with expected value of zero, and an estimate of a security's performance not accounted for by either market return

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 O 69

Table III Performance Measures for the NYSE Screens

Mean
Holding Period 4/74-3/76 4/75-3/77 4/76-3/78 4/77-3/79 4/78-3/80 4/79-3181 4/80-12/81 4/74-3/76 4/75-3/77 7/76-3/78 4/77-3/79 4/78-3/80 4/79-3/81 4/80-12/81 4/81-12/81 4/74-3/76 4/76-3/78 4/77-3/79

Median
Raw Returns Rmt R1i, (% monthly) 2.34 2.88 2.41 2.48 2.23 2.35 3.42 2.23 2.63 0.85 1.05 1.34 1.95 1.74 -0.07 2.55 3.21 2.11 1.57 0.94 1.23 0.05 0.83 1.24 1.92 1.50 0.94 1.23 0.05 0.83 1.24 1.92 1.50 -0.63 0.94 1.23 0.05 0.83 Risk-Adjusted Measures t5) 3.96*** 3.72*** 3.79*** 5.21*** 1.31 1.14 2.59*** 3.88*** 3.11*** 2.94*** 1.09 -0.72 0.71 0.77 0.74 5.38*** 3.95*** 3.78*** 1.69* 1.01 0.99 0.37 1.13 1.23 1.04 0.79 0.89 1.15 0.82 0.89 1.16 0.79 0.60 1.14 0.91 1.01 0.67 0.95 17.64 12.74 1.91 13.61 14.16 15.31 6.95 16.51 16.12 9.75 14.29 20.35 13.56 8.17 4.45 19.19 10.94 3.83 8.46 Risk and Size-Adjusted Measures

Firm Firm Size Size (millions of dollars) 338.9 651.0 327.5 126.0 885.3 323.2 1,497.0 412.1 510.4 408.4 1,169.0 1,927.0 1,302.3 874.3 142.0 793.6 1,364.5 530.7 83.6 65.0 92.2 71.1 70.0 111.1 192.3 209.7 47.4 76.6 81.6 122.3 155.9 244.2 113.2 77.7 59.5 76.8 52.1 63.9

a; (%)

R
0.299 0.222 0.005 0.230 0.262 0.266 0.112 0.266 0.298 0.106 0.218 0.375 0.194 0.103 0.245 0.329 0.176 0.050 0.275

c(%) 6.11 2.42 10.37 5.92 3.64 -1.55 8.30 6.11 2.86 7.65 3.57 0.33 -5.16 1.40 5.97 4.11 6.55 8.85 13.41

t())b 1.77* 1.51 3.31*** 1.41 0.94 -0.43 2.09** 2.05** 1.25 3.69*** 2.08** 0.17 -2.38** 0.60 0.54 1.85* 2.47** 2.31** 1.87* 1.01 0.98 0.69 1.13 1.24 1.04 0.78 0.89 1.15 0.82 0.88 1.16 0.79 0.60 1.14 0.91 1.02 0.67 0.95

t( 17.63 12.70 6.30 13.60 14.12 15.30 6.88 16.50 16.11 9.76 14.28 20.33 13.59 8.17 4.40 19.19 11.24 3.80 8.52

(x 1000) -0.92 -0.46 -1.72 -0.87 -0.59 0.36 -1.29 - 0.95 -0.37 -1.36 -0.63 -0.10 0.99 -0.22 - 1.05 -0.46 -0.97 - 1.42 -2.63

t(5)5 -1.31 -0.98 -2.75*** -1.01 -0.79 0.54 -1.77* -1.56 -0.83 -3.37*** -1.94* -0.28 2.50** -0.49 -0.47 -1.04 -1.89* - 1.83* -1.71*

R2 0.300 0.223 0.068 0.231 0.263 0.284 0.119 0.268 0.300 0.119 0.222 0.375 0.201 0.103 0.248 0.330 0.192 0.062 0.287

*Z U

1.62 1.32 2.10 1.70 .0.58 0.37 1.31 1.48 0.98 0.72 0.28 -0.21 0.21 0.25 0.81 1.81 1.64 1.91 0.77

2 * C

'

Ue

Z 4/75-3/77

U 'n- 4/78-3/80 1,390.6 934.0 4/79-3/81 4/80-12/81 787.2

140.4 198.7 127.6

1.45 1.65 1.84

1.24 1.92 1.50

-0.04 -0.18 0.31

-0.09 -0.56 0.43

1.12 0.89 0.58

13.48 0.346 13.94 0.266 3.51 0.085

1.16 1.14 - 4.53

0.38 0.42 -0.73

1.12 13.46 0.89 13.92 0.56 3.39

-0.23 -0.25 0.92

-0.39 -0.49 0.79

0.356 0.266 0.089

'Significant at 10 per cent level.

** Significant at 5 per cent level.

Significant at 1 per cent level.

or the security'srisk.6For my purposes, this last term-alpha-is a direct estimate of the ability of the criteriatested to select stocks. Several additional tests were performed to determine if any evidence of selective ability found might actually represent a small firm effect. First, I initially analyzed NYSE and AMEXfirms separately. Second, I incorporated a size term into Equation(1) to separate size and selectivity effects. Third, I compared the performance of the tested portfolios with that of portfolios of firms of similar market capitalization. Finally, to determine whether the criteria, if useful, remained so after their publication, I calculatedex postresults for portfolios formed in the four years prior to publication(1973-76)and ex ante results for the portfolios formed in the four years subsequent to publication (1977-80).

Results
Table III presents the mean monthly returns and the risk-adjustedperformancesof the NYSE stocks and Table IV the results for the AMEX stocks. Table V presents the results for the combined exchanges. Each line of each table represents the performanceof a set of securities purchasedon March31 of the year following the December 31 screen and sold either two years later or upon 50 per cent price appreciation.7 Table IIIindicates that use of any of the three

screens on NYSE securities would have almost invariablyprovided raw returns in excess of the marketreturn. Use of criteria(1) and (6) would have resulted in excess risk-adjustedreturns. The performanceestimates for the years prior to publication of the criteria indicate positive excess returns that are both statistically and economically significant. The smallest of the four-1.32 per cent per month-annualizes to an excess rereturnof 17 per cent per year. Both the size and the significance of the excess returns decline after publication. Only the 1979 screen provided statistically significant excess returns, but excess returns for the other years remained positive, and even the 0.37 per cent per month excess return for 1978 amounts to a risk-adjusted excess annual return of 4.5 per cent. For the most part, criteria(3) and (6) and (1), (3) and (6) provided large significant excess returns prior to publication, but mixed results subsequent to publication. The first two columns of TableIIIindicate that the selected securities were not in general those of small firms. It is thus unlikely that the excess returns detected were the result of a small firm effect. The equation was nevertheless reformulated to test for this possibility.8 The results parallel the earlier findings: Screens of criteria (1) and (6) provided significant pre and postpublication excess returns after adjustment for size effects;screens of criteria(3) and (6) and (1),

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 O 70

Table IV Performance Measures for the AMEX Screens

Mean Firm Holding Period 4/74-3/76 4/75-3/77 4/76-3/78 ~..~4/77-3/79 U ..4/78-3/80 4/79-3/81 4/80-12181 4/74-3/76 4/75-3/77

Median Firm Raw Returns Rmt (% monthly) Risk-Adjusted Measures ci (%) 1.23 1.61 1.59 1.81 0.60 1.09 2.21 1.15 1.93 1.04 0.89 1.23 1.16 0.96 1.24 1.45 tVi,tf)
t(a)A3t/)

Risk and Size-Adjusted Measures R2 R d % 7.69 0.54 8.42 6.14 9.85 - 2.24 11.42 6.44 11.90 5.20 4.55 1.37 1.73 1.53 6.25 7.83 t() () 1.71 0.14 1.52 1.31 1.73 -0.34 1.74* 2.29** 2.94** I.93* 1.95* 0.36 0.42 0.31 1.99** 2.18** ( 1.17 1.18 0.62 1.09 1.45 1.10 1.04 0.93 1.00 0.40 0.69 0.97 1.07 0.31 0.90 0.88 (3 16.07 9.89 3.98 9.58 12.27 9.97 4.08 16.09 9.39 3.31 8.24 9.44 10.01 1.65 15.41 5.95

(millions of dollars) 18.2 46.7 16.8 19.2 24.4 18.7 84.0 79.3 32.3 47.0 83.6 47.3 62.7 163.1 44.3 50.4 8.3 10.9 12.0 13.9 11.9 12.3 11.7 10.5 15.0 15.5 21.7 14.5 16.7 18.6 9.8 13.2

R1.,

(x 1000)
- 1.62 0.25 -1.70 - 1.05 - 2.24 0.81 - 2.12 - 1.27 - 2.37 - 0.98 - 0.83 - 0.03 - 0.13 - 0.13 - 1.22 - 2.82

t(S)b

R2
0.266 0.164 0.027 0.148 0.221 0.155 0.119 0.270 0.154

2.02 3.56 1.83 2.45 2.62 3.09 5.12 1.87 3.64 1.32 1.55 2.90 3.11 2.30 1.99 3.17

0.94 1.23 0.05 0.83 1.24 1.92 1.50 0.94 1.23 0.05 0.83 1.24 1.92 1.50 0.94 1.23

2.37** 2.86** 3.59** 4.22** 1.03 2.07** 1.95* 2.75** 3.86** 3. 00** 2.66** 2.49** 2.28** 1.15 3.00** 3.08**

1.18 1.18 0.63 1.09 1.46 1.10 1.06 0.94 1.01 0.40 0.69 0.97 1.07 0.31 0.90 1.01

16.12 9.89 4.00 9.60 12.35 9.97 4.14 16.10 9.45 3.33 8.22 9.45 10.03 1.65 15.42 10.11 5.79

0.264 0.164 0.025 0.147 0.217 0.154 0.106 0.266 0.144 0.017 0.097 0.152 0.195 0.016 0.252 0.163 0.137

- 1.44 0.29 -1.24 - 0.93 - 1.63 0.51 - 1.42 - 1.91* - 2.48**

-

~.4/76-3/78

1.56

4/77-3/79 U ~.4/78-3/80 4/79-3/81 4/80-12/81

0.021
0.100 0.152 0.195 0.017 0.255

- 1.59 -0.04 - 0.14 - 0.12 -1.61 - 1.80*

~ -4/74-3/76 4/75-3/77
U

4/76-3/78
4/77-3/79

68.9
106.3

20.1
25.2

1.45
2.03

0.05
0.83

1.16
1.40

2.74*'*
2.44**

0.41
0.87

2.77 0.019 5.39 0.195 6.13 0.198

5.62
14.20

1.70*
3.25**

1.01 10.05 0.41 2.75 1.05 1.11 5.41 6.11

- 1.50 - 1.03 2.29 0.16

- 1.36
- 2.96**

0 168 0.024
0.171

4/78-3/80 4/79-3/81

20.8 27.2

9.4 14.8

4.60 3.06

1.24 1.92

2.67 1.08

2.90** 1.25

1.05 1.11

-6.64 0.42

-0.77 0.05

1.09 0.08

0.203 a, 190

*Significant at 10 per cent level. **Significant at 5 per cent level.

Significant at 1 per cent level.

Table V Performance Measuresfor the CombinedExchangeScreens(includingall firmsfromTablesIll and IV) Mean Firm
Size

Median Firm
Size

Raw Returns
__ _ _ _ _ _

Measures Risk-Adjusted 5)tc)btc) d (% td) 1.43 1.46 1.86 1.75 0.60 0.71 1.57 1.33 1.42 0.86 0.56 0.37 0.54
0.39 1.23 1.54 1.55 1.47 t(fi) R2

Riskand Size-Adjusted Measures d(%) 3.69 2.90 4.92 4.40 3.63 1.99 8.97 1.78 6.03 5.41 4.03 2.75 0.55
1.65 1.76 2.84
tc)

Holding Period 4/74-3/76 4/75/-3/77 E, .-D 4/76-3/78 C 4/77-3/79 U 4/78-3/80 4/79-3/81 4/80-12181 4/74-3/76 $ 4/75-3/77 4/76-3/78 ( 4/77-3/79 4/78-3/80
.-4/79-3/81

(millionsof dollars) 178.8 368.9 175.0 62.3 460.6 183.9 573.1 252.0 288.4 246.8 666.4 1,136.9
863.9 717.6 95.5 424.0 718.8 260.4

27.8 40.4 38.8 33.1 46.5 61.5 131.0 26.1 32.1 47.2 63.8 79.4
95.1 83.0 29.5 28.4 35.4 33.3

Rmt Rit (%monthly) 2.18 0.94 3.20 1.23 2.13 0.05 2.47 0.83 2.43 1.24 2.69 1.92 3.89 1.50 2.08 3.10 1.06 1.28 2.00
2.36 1.87 0.76 2.28 3.19 1.73

t))

(X 1000)

t(5)b

R2

1.09 4.51~ 1.08 5.19** 0.49 6.62** 1.11 1.65* 1.34 2.34** 1.07 3.29*** 0.87 4.75** 4.94** 4.17** 2.73** 1.41
2.09** 1.24 1.06 5.79** 4.95*** 4.54**

4.32**

23.58 15.51 3.93 16.20 18.43 17.13 8.05 23.41 17.16 8.94 15.62 20.26 16.61
7.64 3.30 24.3 4.59

0.276 0.183 0.012 0.185 0.233 0.197 0.109 0.269 0.204 0.052 0.152 0.256 0.189
0.072 0.100 0.287 0.031

1.74* 1.64 2.45** 1.89* 1.57 1.00 3.18** 2.49** 3.38** 4.00** 3.24** 1.88* 0.35
0.82 0.20

1.09 i.08 0.66 1.11 1.34 1.07 0.85 0.92 1.07 0.64 0.80 1.09 0.88
0.54 0.90

23.55 15.47 6.97 16.20 18.37 17.12 7.91 23.41 17.09 8.91 15.65 20.22 16.60
7.63 3.28

- 0.51 - 0.31 -0.71 - 0.59 - 0.65 - 0.27 - 1.44 - 0.68 - 0.99 - 0.97 -0.72 - 0.48 - 0.00
- 0.25 -0.11

- 1.08 - 0.83 - 1.62 - 1.14 - 1.32 - 0.66 - 2.66** - 1.77' - 2.62** - 3.40** - 2.82** - i.65* - 0.00
-0.63 - 0.06

0.277 0.184 0.038 0.186 0.234 0.198 0.121 0.270 0.210 0.060 0.156 0.258 0.189
0.073 0.100

0.94 1.23 0.05 0.83 1.24

1.92 1.50 -0.63 0.94 1.23 0.05

0.92 1.08 0.64 0.80 1.09 0.88

0.54 0.90 0.90 1.01 0.52

4/80-12181 4/81-12181 4/74-3/76 ~.4/75-3/77 4/76-3/78

1.86*
2.83*** 2.24**

14.87 0.169 9.64 0.188 13.99 0.303

14.68 4.24 0.238 0.098

U
L

4/77-3/79 4/78-3/80
4/79-3/81 4/80-12/81

95.6 1,021.7
732.2 657.1

49.6 81.7
154.5 105.8

1.81 2.30
1.97 1.95

0.83 1.24
1.92 1.50

1.10 2.98** 0.67 1.71*

0.10 0.39 0.34 0.62

0.91 1.11
0.93 0.60

5.08 5.09 13.94 4.85

3.40 - 2.87

4.04** 2.07**
1.60 -0.68

0.90 1.01 0.52 0.91 1.11

0.93 0.59

24.22 15.03 4.57 9.86 13.93

14.68 4.13

- 0.29 - 0.76 - 0.79 - 2.74 - 0.85

- 0.65 0.64

- 0.87 - 2.01** - 1.61 - 3.74** - 1.81V

- 1.57 0.78

0.288 0.177
0.034

0.215 0.308
0.241 0.101

*Significant at 10 per cent level. **Significant at 5 per cent level.

Significant at 1 per cent level.

(3) and (6) provided significant excess returns prior to publication and mixed results after publication. The raw returns of the AMEXfirms, presented in Table IV, indicate a large advantage over the market portfolio that does not seem to decrease either after publication or after adjustment for risk. The excess returns from each

screen for each year prior to publication are statistically significant and economically large. The smallest-0.89 per cent per month-works out to an excess return of 10 per cent per year. The first two columns of TableIV suggest that the majority of the selected AMEX firms were small. The results after adjustment for firm size, however, closely parallel the raw return and

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 O 71

Table VI A Comparisonof the Screens with the AppropriateReinganumMV Portfolios A. Return Comparisons NYSESecurities YearsHeld 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980 Average Median Size MV7 9.3% 126.4 65.9 30.3 62.5 88.1 33.0 119.1 MV2 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980 Average Median Size 27.5% 150.4 88.6 59.3 88.7 91.0 29.8 10.8 (1) & (6) 72.6% 383.9 188.3 70.6 90.0 91.8 41.9 115.9 AMEXSecurities (1) & (6) 52.7% 940.1 210.0 83.0 96.3 155.7 52.0 11.6 B. Risk Comparisons NYSESecurities MV7 High Beta Mean Beta Low Beta 1.28 (1) & (6) 1.23 0.94 0.37 AMEXSecurities MV2 High Beta Mean Beta Low Beta 1.57 (1) & (6) 1.46 1.10 0.63 (3) & (6) 1.07 0.77 0.31 (1), (3) & (6) 1.11 0.89 0.41 (3) & (6) 1.16 0.93 0.60 (1), (3) & (6) 1.12 0.88 0.67 (3) & (6) 44.0% 167.2 84.7 31.6 90.0 103.3 32.4 16.1 (1), (3) & (6) 48.5% 156.9 95.8 49.9 185.0 129.4 (3) & (6) 58.2% 242.2 86.9 11.4 48.5 62.4 19.1 114.9 (1), (3) & (6) 81.3% 330.4 292.3 37.0 70.6 56.4 17.6 102.7

15.4

risk-adjustedreturnresults; for each set of criteria, there are economically large excess returns. Table V shows the results for the combined exchange screens. The CRSP NYSE-AMEX index provided a mean annual return (including dividends) of 14 per cent over the test period. By using Graham's criteria(1) and (6) to select securities from the combined NYSE-AMEX universe, an investor could have achieved a mean annual return of 38 per cent! Use of criteria(3) and (6) and (1), (3) and (6) would have resulted in mean annual returns of 26 per cent and 29 per cent, respectively.9 Although the superior performance of the portfolios created from the selection criteriadeclined after 1976, it did not disappear. Furthermore,the performancedoes not appear to be due either to systematic risk or to size effects.

An Alternative Approach to Size

In a study of the small firm effect, Reinganum divided all NYSE and AMEX securities into deciles according to firms' market capitalizations for the year 1963-80 and found that the two deciles with the smallest firms (MV1 and MV2) had significant positive excess returns, whereas the remaining deciles had negative '0 I compared the two-year holdexcess returns. ing period returns of each of the portfolios formed using Graham's criteria with returns from Reinganum's portfolios of comparably sized firms. Table VI compares the GrahamNYSE securities with the seventh decile (MV7) of Reinganum's NYSE-AMEX population and the Graham AMEX securities with Reinganum's second smallest decile (MV2). The results are similarto

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 O 72

Table VII

Performance Measures for the Screens Including Historical Earnings Growth (including all firms in Tables III and IV)

Mean Firm Size

Median Firm Size

Raw Returns

Risk-Adjusted Measures

Risk and Size-Adjusted Measures

Holding Period
3 Ol5

(millionsof dollars)
226.0 921.0 141.8 39.0 1,053.0 202.6 673.5 533.2 920.4 138.7 29.1 3,122.9 169.5 1,126.9 26.7 46.8 36.6 21.5 65.5 24.9 109.6 53.1 117.1 56.3 25.2 102.4 104.5 96.4

Rmt RAi (%monthly)

2.47 2.91 1.75 2.90 3.44 3.03 4.33 2.45 3.18 1.63 2.96 3.30 2.38 3.54 0.94 1.23 0.05 0.83 1.24 1.92 1.50 0.94 1.23 0.05 0.83 1.24 1.92 1.50

&(%)
1.58 1.02 1.54 2.25 1.37 0.99 1.93 1.65 1.48 1.45 2.42 1.43 0.64 1.55

t(a)

03
1.32 1.16 0.74 1.21 1.34 1.13 0.78 1.00 0.98 0.77 1.11 1.10 0.85 0.61

t()
17.60 10.92 5.63 9.82 13.53 12.32 5.72 10.31 12.78 4.69 3.76 7.92 7.16 2.72

R2
0.309 0.194 0.049 0.185 0.275 0.230 0.089 0.258 0.226 0.091 0.159 0.295 0.164 0.088

&(%)
4.73 1.34 6.56 7.01 6.86 1.24 6.94 4.08 8.85 17.30 11.50 7.34 1.72 -4.66

t(i)b 1.57 0.51 2.43** 1.63 2.69*** 0.47 2.03** 1.02 3.15*** 3.36*** 0.70 2.68X** 0.43 -0.96

/
1.32 1.16 0.74 1.21 1.34 1.13 0.78 1.00 0.96 0.76 1.12 1.09 0.85 0.54

t(,B)
17.58 10.91 5.60 9.83 13.50 12.31 5.76 10.30 12.20 4.69 3.77 7.91 7.14 2.38

(x 1000)
-0.71 -0.07 -1.08 -1.10 -1.14 -0.05 -0.90 - 0.51 -1.41 -3.27 -2.07 -1.15 -0.22 1.30

t5

t(5)b -1.06 -0.12 -1.87* -1.11 -2.19** -0.10 -1.44 - 0.62 -2.65*** -3.09*** -0.55 -2.22** -0.27 1.30

R2
0.310 0.194 0.055 0.187 0.282 0.230 0.095 0.259 0.236 0.129 0.162 0.317 0.161 0.108

s )

4/74-3/76 4/75-3/77 4/76-3/78 4/77-3/79 4/78-3/80 4/79-3/81 4/80-12/81

2.96* 2.03** 4.15*** 4.86*** 2.85*** 2.27** 3.17*** 2.38** 3.96*** 3.05*** 2.16** 2.17** 1.11 1.54

4174-3/76 4/75-3/77 4/76-3/78 .Z ". 4177-3/79 U _ 4/78-3/80 Cf) 4/79-3/81 C 4/80-12/81

o

Significant at 10 per cent level. * Significant at 5 per cent level.

Significant at 1 per cent level.

those presented earlier. For the NYSE securi- provided for significant, excess returns. U ties, portfolios formed from screens of criteria (1) and (6) outperformed the comparablysized portfolios in each period; portfolios formed Footnotes from screens of criteria (3) and (6) and criteria 1. Benjamin Graham, "The Future of Common Stocks," FinancialAnalysts Journal, September/ (1), (3) and (6) outperformed the comparably October 1974, p. 23 sized portfoliospriorto publicationbut not after publication.For the AMEXsecurities, portfolios 2. See P. Blustein, "Ben Graham's Last Will and Testament," Forbes,August 1, 1977, pp. 43-45. formed from each screen generally outperFor a more detailed exposition of the developformed the portfolios of firms of comparable ment of these criteria,see J. Rea, "Rememberinrg size both before and afterpublication.Given the BenjaminGraham-Teacher and Friend,"Journal large differences in the betas of the screened of Portfolio Management, Fall 1977, pp. 16-27. portfolios and Reinganum's comparison portfo- 3. Oppenheimer and Schlarbaumhave provided ex lios, it would appear that the excess returns do ante tests of the criteria in Graham's Intelligent represent selectivity effects of the criteria,rather Investor.See H. Oppenheimer and G. Schlarthan size effects. baum, "Investing with Ben Graham:An Ex Ante

The Value of Additional Criteria

Can one increase returns by including additional criteria?The results presented in Tables III through VI suggest that adding criterion (3) to criteria(1) and (6) resulted in decreased return. I nevertheless tested each security satisfying criterion(9) in addition to the sets of criteria(1) and (6) and (1), (3) and (6). The number of securities meeting the new, more stringent, screens is included in Table II. TableVIIpresents the results. A direct comparison of TableVIIwith Panels A and C of TableV indicates that each screen including criterion(9) provided a small increment in both raw and risk-adjustedperformance." In conclusion, the evidence suggests that Graham's advice was not without merit. It has

Test of the EfficientMarketsHypothesis," Journal of Financial and Quantitative Analysis, September 1981, pp. 341-360 and H. Oppenheimer and G. Schlarbaum, "Investment Policies of Pension Plans and Property-Liability Insurers:A Lesson from Ben Graham,"Journal of Riskand Insurance, December1983, pp. 611-630. Graham'sadvice to the "defensive investor"of Intelligent Investor was intended to result in purchase of large conservative companies and to provide an average (market) return. Despite that, Oppenheimer and Schlarbaumfound that simulated portfolios provided significantpositive excess returns over the 1955-76 period. An earlier version of the present article, emphasizing firm size effects, is available from the authar. 4. These three screens are suggested as being the most useful (and profitable)in the Blusteinarticle and are, perhaps, therefore most apt to be used

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 O 73

by a naive investor. Furthermore, the third screen has the virtue of providing evidence on the value of adding another criterion. A fourth screen-the net asset value criterion-is also stronglyrecommendedand, indeed, the criterion Grahamwas famous for. A separateinvestigation of it is currentlyin progress. 5. Where less than 35 (but more than eight) securities were available, all eligible securities were evaluated. 6. This measure was first introduced by M. Jensen in "The Performance of Mutual Funds in the of Finance,May Period 1945-1964," TheJournal 1968, pp. 389-416. 7. Thus, for a screen of December 31, 1977, purchase was March 31, 1978 and sale March 31, 1980. Note that the CRSPdata tapes used ended December 31, 1981. Thus the 1979 screens have only 21 months and the 1980 screens only nine months of data. 8. The logio of firm marketcapitalizationwas added to separatesize and selectivity effects. The use of a separate size term is suggested by M. Reinganum in "A Direct Test of Roll's Conjectureon the Firm Size Effect," Journalof Finance,March 1982, pp. 27-36. 9. In comparison, Blustein provides a summary of the returns that would have been available between 1925and 1975, the period of historicaldata

Graham used to develop his criteria. Blustein reports that for screens of criteria(1) and (6) and (3) and (6) average annual compound returns (excluding dividends and commissions) amounted to 19 and 18.5 per cent, respectively, versus an averageannual returnof 3.5 per cent for the Dow Jones industrialaverage. 10. See M. Reinganum, "AbnormalReturnsin Small Firm Portfolios," Financial Analysts Journal, March/April 1981, pp. 52-56 and M. Reinganum, "PortfolioStrategiesBased on MarketCapitalization," Journalof PortfolioManagement,Winter 1983, pp. 29-36. 11. For the analyses relying on estimation of the equation, the R-squaredis fairly low, compared with the earlier Oppenheimer and Schlarbaum work. Utilization of the size variable did not increase R-squaredsignificantly. The major reason for the low values appears to be the large numberof large monthly securityreturnobservations. For the screens of criteria(1) and (6), 12.2 per cent of the market observations of return were greaterthan 6 per cent, whereas 30 per cent of the firm observations were greater than 6 per cent. This large disparity is likely caused by the fact that about 8 per cent of these firms were acquired during the simulated holding period while another 7 per cent were acquired during the two years subsequent to the holding period.

Earnings Expectations
concluded from page 38

lent to an average monthly compound rate of return of 4.36 per cent. Thus, given an initial investment of $100, the portfolio's trendline value would be $104.36afterone month and $108.91 after two months. The actual value of the portfolio afterone month, however, was $110.50,or 5.9 per cent above trendline. After two months the actual value was $106.90, or 1.9 per cent below trendline. Based on returns over a 12-month period, one can obtain 11 monthly observations of this type, because the beginning and ending values of the portfolio are coincident with the beginning and ending values on the trendline as we have defined it. The mean absolute deviation over a one-year period is then found by calculating the absolute average of the 11 interim-monthly deviations derived in the above manner. 9. Based on a simulationinvolving 35.2 million trials in which there were only seven occasions where the mean of 24 drawings (from 24 sampling populations that contained the numbers one through 1,000)was greaterthan 783. The highest sample mean was 802. of Portfolio 10. From the Fall 1974 issue of TheJournal Management.

BALTIMORE GAS AND ELECTRIC COMPANY

DIVIDENDS INCREASED ON COMMON STOCK Dividends have been declared for the quarter ending September 30, 1984 at the following rates per share: Common Stock-80 cents (previously 75 cents). Preferred and Preference Stock-at the specified rates. All are payable October 1, 1984 to holders of record at the close of business on September 10, 1984. B.C. TRUESCHLER
Chairman of the Board

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1984 O 74