Ben Graham and David Dodd are often cited as the fathers of fundamental analysis. That means examining corporate financial statements, calculating various ratios based on the data, and using those to assess the health of companies, and, presumably, the investment merits of their shares.
Today, that sounds so mundane. But when they first published their textbook in 1934, it was quite novel. The fact that is seems old hat today is testament to how thoroughly those ideas have since permeated the investment landscape.
In 1973, Graham published The Intelligent Investor, which applied the fundamental analytic approach to the actual process of running an investment portfolio, and this is the book usually cited today by those who seek to develop Graham-based All-Star strategies.
Not surprisingly, value is an important consideration. Graham specifically advises against price-to-tangible book value ratios above 1.20, and is very much attracted to low P/E ratios. But casual observers tend to underestimate his sensitivity to company quality. Graham was very much aware of how low valuation metrics might exist because those are what the company deserves, usually based on poor prospects. So a Graham All-Star strategy cannot be based on value alone.
As to Graham's approach to evaluating company quality, we must consider his era. As noted, the Graham-Dodd textbook is a product of the 1930s, and even Graham's own latter work stems from another horrible period from the stock market, the 1968-73 bust. It often seems as if, to him, a company that was simply in the black and likely to avoid bankruptcy, could be considered pretty good. Given the environment in which he worked, who could blame him for such a conservative view.
Interestingly, though, despite the fact that modern investors are so much more demanding, Graham's standards seem pretty effective even today, as can be seen below in the results of our testing of our Graham-based All-Star model. Perhaps it takes a Ben Graham to remind even the most gung-ho among today's breed that if you are sufficiently sensitive to value, and as long as you're aware of the most basic elements of company quality, you don't really have to be too demanding with regard to the latter.
The Portfolio123 Ben Graham model
This model reflects the general principles used by Portfolio123 for its All-Star screens (stand-on-their-own models inspired by key elements of the All-Stars' approaches), which can be seen here.
The Portfolio123 Ben Graham model starts with no restrictions at all regarding company size. As Graham said on page 210 of The Intelligent Investor, "we set no lower limit on the size of the enterprise. Small companies may afford enough safety if bought carefully and on a group basis." From there, we screen based on Graham's company-quality ideas (specifically, we're following the approach for what he refers to as the "enterprising" investor). Here are the details:
Liquidity filter: Universe(foliofn), which means the stock must be tradable in the Folio Investing.com window system; for backtesting purposes, substitute a rule that bars OTC stocks. (Click here for more information)
Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek
Current ratio must be at least 1.5
Long-term debt must be no higher than 10% above working capital
EPS must be above breakeven in each of the last four quarters and in each of the last five annual periods
Trailing 12 month EPS most be above EPS in the latest annual period
EPS in the latest annual period must be above EPS in the prior year and five years ago
The company must have paid common dividends in the last 12 months
Notice the absence of value screening rules. That is deliberate. The world has changed much even since Graham's latter work and it is no longer reasonable to expect to find shares of respectable companies selling for less than ten times normal levels of EPS. We believe replication of any Graham-stated numeric threshold would be a needless anachronism and would be recognized as such by Graham himself. (For further discussion of Graham-Dodd concepts in today's world, see A Modern Approach to Graham and Dodd Investing by Thomas Au.)
We believe we can fully and properly address value through the Graham ranking system we created. Value is weighted 60%, and 70% of that category comprise two important Graham concepts; price-to-tangible book and price-to-operating earnings adjusted to eliminate unusual items that typically appear in the operating earnings figures published in most of today's databases.
As to the 40% of the model that reflects growth, half addresses stability of growth (defined as low volatility), another important Graham concept albeit not one specifically listed in the laundry list of rules found on page 209 of The Intelligent Investor. The rest of the growth score is based on five-year average return on investing being in excess of industry average. This is a bit more "demanding" in terms of company quality than are the details of the enterprising investor rules list. But it represents a modest nod (half the growth score, or 20% of the total rank score) to the modern quest for more, but one which is very much consistent with the approach laid out in the earlier Graham-and-Dodd work.
Here, then, is the ranking system we use as a basis for selecting the top 15 based among those stocks that pass the Graham screen:
Valuation - 60% of total
Trailing 12 month P/E (15% of this category)
Earnings - 40% of total
Price-to-Book (15% of this category)
Price-to-Tangible Book Value (35% of this category)
Operating P/E, defined as Market Capitalization divided by Business Income, which is Sales minus Cost of Goods sold minus Selling, General & Administrative Expense and omits unusual items (35% of this category)
5-year EPS Growth Rate (50% of this category)
EPS Stability, defined as the standard deviation of EPS over the past 16 quarters, lower being better (50% of this category)
Portfolio123 users who would like to examine the details or copy the models for their own use, may do so:
Click here for the Ben Graham screen
Click here for the Ben Graham ranking system
Figure 1 and Table 1 show the results of a five-year backtest that ran through 1/12/10 which assumes rebalancing every four weeks and selection of the top 15 stocks as per the screen sorted on the basis of the Ben Graham ranking system.
The above-market downside performance is consistent with what many would associate with Graham. But the comparable upside excess performance will probably come as a surprise to most observers. Bottom line: When it comes to Ben Graham, check your stereotypes at the door.