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FEATURE

Graham’s Simplest Approach to Selecting Stocks

by John Bajkowski
For over 70 years the works of Benjamin Graham have served as the bible for value investors.
Successful money managers such as Warren Buffett and John Neff swear by the simple message
put forth by Graham of looking for values with a significant margin of safety.

Reviewing the philosophy of successful investors such as Benjamin Graham can often prove
enlightening. Graham’s philosophy continues to flourish primarily through two books—Graham and
David Dodd’s "Security Analysis" and Graham’s "The Intelligent Investor." "Security Analysis" was first
released as a college textbook; it examines the fundamental investment process by covering analysis of
the economy, industries, financial statements, and bonds and stocks. McGraw-Hill owns the rights to
this book and still publishes a number of textbook editions including the original 1934 version.

Print this article The first edition of "The Intelligent Investor" by Graham was released in
1949 and geared toward the individual investor. Grahams last revision was
Printer- & mobile-
friendly version released in 1973. Subsequent revisions have left the original chapters
written by Graham in the early 1970s largely unchanged, with additional
Download printable
commentary presented separately. "The Intelligent Investor" presents
PDF
Graham’s basic philosophy on holding a mix of bonds and stocks and
In this article selecting stocks for both the defensive investor and the enterprising
investor. HarperCollins Publishers offers several editions of "The Intelligent
Price-Earnings
Investor," ranging from the original 1949 edition with a foreword from John
Ratio
Bogle to a revised 2003 edition with commentary by Jason Zweig.
Financial Position

Minimum Graham’s approach focused on the concept of an intrinsic or central value

Portfolio Size that is justified by a firm’s assets, earnings, dividends, financial strength
Sell Discipline and stability, definite company prospects, and quality of management. By
Following the focusing on this intrinsic value, Graham felt that investors could avoid
System being misled by the misjudgments often made by the market during
Applying the periods of deep pessimism or euphoria. This contrarian view dictates that
Screen stocks will appear most attractive when they are relatively unpopular with

Testing the the market. The selection process takes great conviction and discipline
Strategy because the momentum of the stock market will seemingly be against the
investor, and there may be no clear indication as to when the market will
Portfolio
Characteristics come around to agree with you. However, in Graham’s opinion the
possibility of extraordinary gains only exists when the investor disagrees
Conclusion
with the market.

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In "The Intelligent Investor," Graham laid out specific quantitative rules to
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follow when selecting stocks for the conservative investor. These rules
shaped the Graham defensive and enterprising screens featured on
Twitter AAII.com and built into Stock Investor Pro, AAII’s fundamental stock
research and screening program.
E-mail
Recently, an AAII member informed us that Heilbrunn Center for Graham &
SeekingAlpha Dodd Investing at Columbia University maintains an on-line archive of
articles by and about Benjamin Graham
( http://www7.gsb.columbia.edu/valueinvesting/research/schlossarchives ). These
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articles highlight the fact that Benjamin Graham continued to study and
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test different stock selection approaches until his death in 1976.
About the author An interview with Graham published in the September 20, 1976, edition of

John Bajkowski is
Medical Economics lays out a simplified value approach to building a stock
portfolio that any investor should be able to easily follow.
president of AAII.
• John Bajkowski Profile
Determining the appropriate price to pay for a stock is the critical issue for
• All Articles by John
a value investor. Graham believed that at any point in time there are a
Bajkowski
large number of securities that are priced too high as well as a large
number of stocks that are priced too low. Graham felt that if you put
together a large enough diversified portfolio of low-priced stocks, then you
could skip getting involved in the fundamental analysis of specific companies or industries.

The key is using a rule for purchasing stocks that indicates a priori that they are undervalued.
Secondly, when focusing on a single rule to select stocks, you must purchase enough stocks to make
the approach effective. Finally, a sell discipline must be established.

Price-Earnings Ratio
The price-earnings ratio, or earnings multiple, is one of the most popular measures of company value.
It is computed by dividing the current stock price by earnings per share for the most recent 12 months.
It is followed so closely because it relates the market’s expectation of future company performance,
embedded in the price component of the equation, to the company’s actual recent earnings
performance. The greater the expectation, the higher the multiple of current earnings investors are
willing to pay for the promise of future earnings.

If the market has low earnings growth expectations for a firm, or views earnings as suspect, it will not be
willing to pay as much per share as it would for a firm with high and more certain earnings growth
expectations.

However, investors often pay too much for companies that appear to have the best prospects at the
moment and react too negatively to companies considered to have the weakest prospects. This
mistake tends to be a self-correcting process that value investors can use to their advantage.

Graham’s simplest investing approach relies on selecting stocks trading with a low price-earnings ratio.
How low? Graham suggests one way to determine the maximum acceptable price-earnings ratio is to
look at what high-quality bonds are yielding. If bond yields are high, you would want to select stocks
selling cheaply—screening for relatively low price-earnings ratios. If bond yields drop, then you could
pay more for a stock and therefore screen for stocks with a higher price-earnings ratio. Graham’s rule
of thumb is to select only those stocks whose price-earnings ratios are less than inverse of double the
AAA bond rate. You would double the bond yield and divide the result into 100.

At the time of interview, the average current yield of AAA bonds was around 7%. Doubling the rate
gives you 14, and 14 goes into 100 roughly seven times (100 ÷ 14). The most Graham would pay for a
stock in 1976 was seven times earnings. If a stock’s price-earnings ratio was higher than seven, it
would not be included.

If the AAA bond yield drops to 6%, then the maximum acceptable price-earnings ratio is eight—double
six is 12; 100 divided by 12 is around eight.

High-grade corporate bonds are currently yielding around 5.25%. This translates into a maximum
acceptable earnings multiple of around 9.5 [100 ÷ (5.25 × 2)].

However, Graham set some absolute limits. He felt that one should never buy a stock with a price-
earnings ratio above 10 no matter how low bond yields go. Conversely, a price-earnings ratio of seven
would always be acceptable no matter how high bond yields may go. When calculating the price-
earnings ratio, Graham believed it was important to relate the price to the historical trailing earnings,
not projected earnings. While Graham thought items such as projected earnings were significant in
theory, he felt it was more practical to use the observed historical earnings figure.

Financial Position
While Graham believed that low-price-earnings ratio stocks would help establish a pretty good portfolio,
portfolio performance could be improved if investors also selected companies with a satisfactory
financial position. Graham used many tests of financial strength, but favored a simple rule that a
company should own at least twice what it owes. There are a couple of easy ways to test for this
situation. You could compare the ratio of stockholders equity to total assets and require a ratio of a
least 50%. Alternatively, you could look at the ratio of total liabilities to total assets and require a ratio
of 50% or less.

A strong financial position provides maneuvering room as a company expands or if it experiences

trouble. Graham used this simple rule because it considers all forms of liabilities.

Minimum Portfolio Size

Graham felt that when using this simple selection method investors had to hold a larger number of
stocks. Lack of in-depth company analysis can only be overcome through a diversified portfolio. A
portfolio of 30 stocks was considered the ideal minimum. If your capital was limited, Graham suggesting
purchasing odd lots (less than 100 shares of stock) when building your portfolio.

Sell Discipline
Graham suggested that investors set a profit objective when buying stocks, and he thought that a 50%
profit goal should provide good results. Under this rule, a stock is sold once it is up 50%.

Furthermore, a time limit must be set for a stocks maximum holding period in advance. Graham’s
research indicated that a holding period of two to three years worked out best. If you establish a
maximum two-year holding period, you would sell a stock after two years if it did not meet its profit
objective.

Following the System

While Graham felt that this approach could produce consistent results over the long run, there was the
possibility of poor short-term performance. Graham suggested that investors looking to follow this
approach should be committed to a minimum five-year horizon. This means being prepared, both
financially and psychologically, to handle a short-term loss. Graham pointed out how the strategy would
have done poorly in the bear market of 1973 to 1974, but then would recoup its losses in 1975 to 1976.
Overall, Graham felt that this strategy was capable of producing a long-term total return (capital gains
plus dividends, less commissions) of 15% per year. Like all systems, it is important to trust it and let it
run its course so that the statistical probabilities would operate in the investors favor.

Applying the Screen

We thought that it would be interesting to test how this simplest of Graham strategies would have
performed in our mixed market environment of the last several years.

Stock Investor Pro, AAII’s fundamental stock screening and analysis program, was used to construct a
hypothetical 30-stock portfolio at the start of 1998. Grahams sell and buy rules were then used to
manage the portfolio over time.

Some slight modifications and additions to the screening filters were made in constructing the
hypothetical portfolio. Starting with the December 31, 1997, edition of Stock Investor Pro, the first filter
excludes non-exchange listed stocks. Over-the-counter stocks are typically smaller companies with
more limited liquidity that may require additional analysis. The December 31, 1997, edition of Stock
Investor Pro contained a universe of 8,261 companies; excluding over-the-counter stocks left us with
7,786 stocks.

Next, stocks classified as part of the Miscellaneous Financial Services Industry were filtered out. This
industry classification is normally applied to closed-end mutual funds by Reuters—Stock Investor Pro’s
primary data source—and the Graham strategy focuses on common stocks. This filter further reduced
the list of passing companies to 7,663 stocks.

The next conditioning filter excluded foreign-listed stocks trading as ADRs. Many of these companies
release their primary financial statements in a currency other than dollars and may have different
reporting requirements than domestically listed companies. While values might exist within this group of
companies, they typically require additional analysis to ensure that their financials and ratios are
comparable to domestic stocks. Excluding these foreign ADRs reduced the list of passing companies by
145, leaving 7,518 stocks. Liquidity, or the ability to buy and sell a stock quickly and without
substantially moving the price is an important consideration for investors. There are many possible
screens for liquidity. The screen already required that a stock be listed on an exchange, but we also
required that a stocks price be at least five dollars. This minimum price is used as a test for determining
if a stock can be purchased on margin and was applied to the Graham screen to ensure minimum
marketability and to avoid penny stocks. This filter reduced the list of passing companies from 7,518 to
5,763 stocks.

Table 1. Year-by-Year Performance of Graham Screen and Indexes

Ret urn (%) Std

Dev
1998 1999 2000 2001 2002 2003 2004 YTD* Cuml*
(%)

Graham -2 7 .1 1 4 .4 - 4 .1 4 4 .4 5 .6 4 4 .1 2 6 .1 1 1 .6 1 4 7 .5 5 .5

S&P 5 0 0 2 6 .7 1 9 .5 - 1 0 .1 -1 3 .0 -2 3 .4 2 6 .4 9 0 .8 2 5 .9 4 .7

S&P M idC ap 4 0 0 1 7 .7 1 3 .3 1 6 .2 -1 .6 -1 5 .4 34 1 5 .2 7 .3 1 1 3 .4 5 .6

S&P S mallC ap 6 0 0 -2 .1 1 1 .5 11 5 .7 -1 5 .3 3 7 .8 2 1 .4 5 .7 9 1 .8 5 .9

A ll E xc hange-L is ted Stoc ks 5 .9 3 5 .1 - 1 4 .2 2 1 .2 -1 3 .3 8 1 .1 2 2 .8 2 .2 1 9 3 .3 6 .7

*Price performance of hypothetical portfolio rescreened and rebalanced monthly using month-end
closing prices and no transaction costs.

Data as of August 31, 2005.

The two primary Graham criteria were then applied to this universe of stocks. The prevailing long-term
yield for high-quality bonds at the end of 1997 was around 9.5%. This results in a maximum allowable
price-earnings ratio of around five [100 ÷ ( 9.5 × 2 )]. However, Graham indicated that a stock with a
price-earnings ratio below seven should always be considered, so seven was used for this screen. Only
215 companies out of the total of 8,261 companies tracked by Stock Investor Pro at that time had a
price-earnings ratio of seven or lower. Adding this filter to the other criteria dropped the number of
passing companies from 5,763 to 89.

Graham’s financial strength requirement was then applied to the screen. Graham does not want total
liabilities for a company to be more than half the level of total assets. Stock Investor Pro reports on the
ratio of total liabilities to total assets, so a criterion specifying that this figure be no more than 50% was
added to the Graham screen. Around 3,500 out of the 8,261 companies in the Stock Investor Pro
universe met this requirement. Adding this filter to the Graham screen left the 30 companies that were
used to construct the initial hypothetical portfolio.
 Novell, Inc. (M: NOVL) 5.86 12.1 3.4 6.57 7.7 4.94 4.2 47.7 Softw are &
May
2005
United Online (M: UNTD) 12.94 0.7 3.1 13.03 13.35 8.51 7 39.2 Computer S
May
2005
GP Strategies Corp. (N: GPX) 8.14 3.6 3.5 8.43 8.95 6.4 6.5 35.4 Business S
Jun
2005
Louisiana-Pacific Corp. (N: LPX) 24.58 2.9 3.5 25.29 28.73 22.06 8.4 45.7 Forestry &
Jun
2005 Constructio
Maverick Tube Corp. (N: MVK) 29.8 6.9 3.6 31.85 36.89 25.4 8.2 43.8
Jun Fixtures
2005
Programmer's Paradise (M: PROG) 10.05 -6.5 3.1 9.4 16.15 8.1 6.9 42.8 Softw are &
Jun
2005
Reliance Steel & Aluminum (N: RS) 37.07 29.5 4.4 48 49.83 33.08 8.7 43.1 Misc Fabric
Jun
Cobra Electronics Corp. (M:
2005 Jul 8.79 -4.8 4.1 8.37 9.85 6.31 6.2 23.8 Communica
COBR)
New Valley Corp. (M: NVAL) 2005 Jul 7.4 -0.7 4.2 7.35 7.98 4.57 9.5 4.1 Real Estate
Rex Stores Corp. (N: RSC) 2005 Jul 15.45 -0.3 4.3 15.41 18.63 12.6 5.2 34.3 Retail (Tec
Devcon International Corp. (M: 2005
10.75 0 3.8 10.75 18.8 10.3 6.9 39.2 Constructio
DEVC) Aug
2005
Seaboard Corp. (A: SEB) 1,284.00 0 3.5 1,284.00 1,850.00 505 6.8 46.4 Fish/Livest
Aug
2005
Talk America Holdings (M: TALK) 9.2 0 3.8 9.2 11.75 4.96 6.6 34.7 Communica
Aug
Exchange Key: N=New York Stock Exchange, A=American Stock Exchange, M=NASDAQ National or NASDAQ Small Cap Marke

Source: AAII's Stock Investor Pro / Reuters Research Inc. Data as of 8/31/2005.

Testing the Strategy

To test the strategy, roughly equal dollar amounts were invested in the 30 stocks passing the Graham
screen. The closing monthly price was used to determine the number of shares to purchase, and the
date of purchase and cost was noted to determine portfolio sells.

Figure 1. Normally when we test a strategy, the screen is run every month and only
P erformanc e of the G raham Sc reen
those stocks passing the screen continue to be held, while new stocks
that pass the screen are added. For this test, however, we held each
stock in the hypothetical portfolio until it was up at least 50% on a split-
adjusted basis during a month-end portfolio status check. If the stock
was up at least 50% over the original month-end purchase price, it was
sold and the proceeds invested in a company that passed the screen
that month. Stocks were also sold if they failed to reach the 50% price
appreciation objective after two years. We also sold stocks if they were
C LIC K O N I M A GE T O
SE E FU LL SI ZE . delisted, did not meet exchange filing requirements or were acquired. We
did not include any commission costs in our calculation, take any time
slippage (time between analysis and actual purchase) into account,
consider the bid-ask spread when buy or selling stocks, or account for
dividend income. Stock positions were not rebalanced, so some individual positions became larger than
average, and the reinvestment of losing stocks would lead to smaller-than-average positions.

The results of the screen are presented in Figure 1 and Table 1. As the chart and table show, the
strategy got off to a terrible start—losing 27.1% in 1998. The market was focused on growth stocks,
and the stocks initially selected by the strategy were out of favor and falling further out of favor. The
year 1998 is the kind of year that would test your conviction in a strategy. As subsequent years
highlight, the strategy righted itself and started to clearly outperform the S&P 500 index starting in
2000.

Table 3. Portfolio Characteristics

A ll
Port f olio Characteristics (Median) Graham Exchange-
Screen List ed
Stocks

P ric e- earnings ratio (X) 7 .2 2 0 .1

P ric e- to-book-value ratio (X) 1 .5 6 2 .2 2

P ric e- to-s ales ratio (X) 0 .8 1 .8 7

E P S 5 -yr. his toric al growth rate (% ) 2 1 .9 5 9 .9

E P S 3 -5 yr. es timated growth rate (% ) 1 1 .4 1 4 .5

M arket c ap. ($ million) 623 4 1 4 .3

Relative s trength vs . S&P (% ) 8 3

Portfolio Characteristics
The companies that make up the current hypothetical portfolio are presented in Table 2. The
companies in the table are sorted by the date they were added to the portfolio, with the oldest holdings
listed first. The portfolio consists of a diverse collection of firms.

As revealed by the portfolio characteristics in Table 3, the portfolio as a whole has a very low median
price-earnings ratio, 7.2 compared to the 20.1 median value for all exchange-listed companies. All of
the stocks added to the Graham portfolio possessed low price-earnings ratios when they were added to
the portfolio, but price appreciation and/or earnings declines have pushed the ratio up for a number of
securities. Janus Capital has the highest price-earnings ratio of 29.4, due to declining historical
earnings per share since purchase. A couple of stocks currently have negative earnings, so a price-
earnings ratio cannot be calculated.

The median market capitalization (share price times number of shares outstanding) for the stocks in the
hypothetical portfolio indicates that the portfolio would currently be characterized as a small-cap
portfolio.

Over 70 companies currently pass the simple Graham screen. The 30 stocks with the lowest price-
earnings ratios are presented in Table 4. The table is dominated by companies in the iron and steel
industry and shipping industry. In building portfolios, Graham emphasized diversification, so you would
need to pass-up some of these companies.

Table 4. Com panies Currently Passing Graham Screen (Ranked by Price-Earnings Ratio)

52-Week EPS
5-Yr
Total Hist
Current P/E Liab to Grow th
Price High Low Ratio Assets Rate
Com pany (Exchange: Ticker) ($) ($) ($) (X) (%) (%) Industry
Telesystem Int'l Wireless (M: TIWI) 16.42 17.82 8.8 1.6 0.6 14.9 Communications Services
Leap Wireless Int'l (M: LEAP) 34.16 37.47 19 2.1 31.4 42.2 Communications Services
Ashland Inc. (N: ASH) 60.79 72.2 51.67 2.2 45.9 7.4 Construction Services
Paulson Capital Corp. (M: PLCC) 10.77 19.88 5.41 2.8 27.8 -14.5 Investment Services
Elron Electronic Indus (M: ELRN) 12.96 17.99 12.03 3.3 18.9 7.2 Medical Equipment & Sup
Hallw ood Group Inc. (A: HWG) 77.5 159 52.2 3.5 31.3 82.2 Textiles - Non-Apparel
Leucadia National Corp. (N: LUK) 40.72 47 32.4 3.5 42 -9.9 Conglomerates
Gerdau Ameristeel Corp. (N: GNA) 5.1 7.39 4.13 3.7 44 na Iron & Steel
Olympic Steel. (M: ZEUS) 16.6 30.3 13.07 4 44 81.3 Misc Fabricated Products
Orbital Sciences Corp. (N: ORB) 11.98 13.1 8.84 4 39.9 21.3 Aerospace and Defense
Griffin Land & Nurseries (M: GRIF) 25 31 20.52 4.2 23.7 70.5 Retail (Home Improvemen
Novell, Inc. (M: NOVL) 6.57 7.7 4.94 4.2 47.7 -32.0 Softw are & Programming
Ditech Communications (M: DITC) 7.36 26.87 6.32 4.5 6 12.7 Communications Equipme
Novamerican Steel (M: TONS) 29.9 90.27 20.75 4.7 41.7 37.8 Iron & Steel
Insteel Industries, Inc. (M: IIIN) 14.3 21.89 8.14 4.8 41.3 24.4 Construction - Supplies &
Tsakos Energy Navig'n (N: TNP) 38.78 46.1 27.69 4.8 45.7 100.1 Water Transportation
General Maritime Corp. (N: GMR) 37.36 53.98 27.85 4.8 34.2 131.2 Water Transportation
Conclusion
The simplest of Benjamin Graham’s approaches to selecting bargain stocks illustrates that it is possible
to beat the market over the long run with a very simple, but well-thought-out strategy. Graham’s
approach reinforces the importance of establishing a sell discipline to take reasonable profits, and to
let go of stocks if they do not pan out as expected. It is only possible to follow such a simple strategy
when building a relative large portfolio of stocks. If you carefully analyze companies before adding them
to your portfolio, it is possible to hold a smaller portfolio, but with a simple screen, Graham felt it was
important to hold a larger number of securities. Most importantly, before following any strategy, you
must be prepared emotionally and financially to deal with the downturns that will inevitably occur.

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Discussion
Ted from California posted over 2 years ago:

I w onder if the current dramatic manipulation of both long and short term interest rates by the
Fed w hich also affects corporate rates w ould invalidate Graham's calculation of p/e ratios.

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In This Issue
FEATURE
Graham’s Simplest Approach to Selecting
Stocks
How w ould Benjamin Graham’s classic value
investing approach to choosing stocks have fared
since 1998? A look at the results of a hypothetical
portfolio.

AAII ONLINE
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ALSO INCLUDED
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Comments on the timelessness of Benjamin Graham's
approach to stock picking.

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