We've discussed in the past some of the more familiar value/bargain screening criteria that can be derived from Benjamin Graham's earlier work, e.g the NCAV and Enterprising Investor Screens. What may be less known to you, though, is some quantitative work that Graham did towards just before his death (known as his quot;Last Willquot;) with the help of a aeronautical engineeer James Rea, where he first identified the 10 best-performing stock selection criteria and then apparently distilled them into the 3 most important criteria.Background It seems that, upon reading an article that Graham had written for Barron’s—“Renaissance of Value”— Rea forwarded some of his quantitative/screening research to Graham. This led to a three-year working relationship before Graham died, which culminated in two articles, one by Rea and one by Blustein (for Forbes) where they set out the findings of the research based on 50 years of back-testing as to the most effective value screening criteria for the US market. Benjamin Graham's 10 Rules for Stock Selection Here's the list that Graham came up with. The idea behind the rules is that the first five measure quot;rewardquot; (by pinpointing a low price in relation to key operating results like earnings) and the second five quot;riskquot; (by measuring financial soundness and stability of earnings).
Unfortunately, the issue with these criteria is that, if all 10 are used, the criteria are just too onerous and are unlikely to result in a meaningful number of picks, especially with changing market conditions and business practices over time. The question which Graham and Rea explored is whether certain criteria can be preferred over others?
The caveat here is that we've unfortunately not yet managed to get hold of the Graham-Blustein article, so this is based on secondary material. However, this source indicates that Graham found that the earning yield and the dividend yield criteria (i.e. the criteria numbered 1 and 3) to be by far the most important performance criteria, while also finding that criteria 1 in combination with criteria 6 would perform almost as well as all 10. Blustein (who wrote up the work for the Forbes article) apparently suggested that criteria 1, 3 and 6 were the most profitable (similar results have been found on the Johannesburg stock exchange). This ties to another source which indicates that
quot;Graham stated in a lecture at UCLA that if an investor just used earnings yield, dividend yield, and debt to tangible equity, they would get results double the DJIAquot;.
Does it work? The ten rules apparently produced market-beating returns for five of the six decades that Ben tested it on. Subsequent testing by Henry R. Oppenheimer from 1974 to 1981 found that:
quot;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, respectivelyquot;.
Before anyone gets too excited, though, it's worth noting that, after Graham died, Rea used the formula in a mutual fund known as the American Diversified Global Value Fund. Run by Rea’s son, it seems that it didn’t do well at all but we don't have any details on why - it may have been a management issue, rather than the rules themself. Interestingly, Old School Value has done some fascinating back-testing more recently for the US market which suggest that it does still work. Interestingly, though, he found that a combination of criteria 1, 2, 6 amp; 7 worked best - and didn't find criteria 3 (yield) to be additive.
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updated Feb 13, 2012
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