Ben Graham, the legendary investor, in his Investments classic, the intelligent investor, recommends that a defensive investor should choose between two approaches (Benjamin 1973): (1) buying a low-cost index fund, which will assure market return with minimal effort, or (2) applying a set of standards to each stock purchase to improve one's odds of beating the market. He recommends the following stock screens:
2 From Stock Selection to Portfolio Alpha Generation: The Role of Fundamental Analysis, Journal of Applied Corporate Finance, Vol 18 No 1, Winter 2006
Graham's idea here is to exclude small companies, which may be subject to more than average volatility (or illiquidity, or neglect). He does note that there will often be good opportunities in smaller stocks, but this is probably not for the "defensive" investor. In 1973, he recommended not buying stocks with less than US $100 million in sales and $50 million in assets.
For industrial companies, Graham looked for current assets to be at least twice the current liabilities (current ration > 2). Also, long-term debt should not exceed the net current assets (or "working capital").
3. Earnings stability
The company must have positive earnings in each of the last 10 years.
4. Dividend record
The company must have paid dividends without interruption over the previous 20 years.
The company must have experienced a minimum increase of at least one-third (33%) in per share earnings (EPS) in the past 10 years using 3-year averages at the beginning and end.
6. Moderate price/earnings ratio
The prevailing stock price should not be more than 15 times average earnings of the past 3 years (historical PE < 15).
Current price should not be more than 1.5 times book value. However, a PE < 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, Graham suggests that the product of the PE and (ratio of price to book) should be less than or equal to 22.5 (which again corresponds to a stock price that is 15 times earnings and 1.5 times book value).
These screens are designed to eliminate most stocks from an investor's radar screen by excluding companies that are (1) too small, (2) in relatively weak financial condition, (3) with a deficit stigma in their 10-year record, and (4) not having a long history of continuous dividends. Obviously, looking at 10- to 20-year track record is easier in the mature markets of the United States and Europe, but probably too restrictive in young markets of Asia. Nonetheless, the concept remains sound.
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