Ben Graham’s rules

Graham had 10 rules for stock selection. The 10 rules are listed in a Stockopedia article from 2012. To simplify the situation further, it turns out that “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”.

The abbreviated rules are:

  • Rule 1: An earnings-to-price yield at least twice the AAA bond rate
  • Rule 6: Total debt less than book value

If you Google for “AAA bond yield”, you will see that it is 3.91%. This implies that you should pay a maximum PE of 12.8 (0.5/0.0391). Disallow loss-making companies.

John Dorfman basically uses these two rules in his Dorfman Robot, which he has been doing for years. The results are very encouraging, but you do not, of course, always beat the market.

I remember applying the Dorfman Robot in the early 2000’s, with fantastic results. Bear in mind, though, that that was a period in which all value strategies performed well. Broader shares struggled as they tried to shake off their excess valuations, particularly amongst the high growth stocks.

Out-performance then seemed to trail off, as shares became more in-balance.

I seem to recall, too, that sometimes excessive debt had superior returns. I think a lot has to do with what style is in or out of favour, and whatever quirks there are when you invest.

It may be that the rules are not necessarily sacrosanct. You might choose, say, a PE ratio less than the mean of the market, and net debt less than three times pre-tax profit, if it’s more convenient. I am just speculating, though.

If you think momentum might be a positive factor too, then maybe you could demand that the relative strength over 1 year is positive.

Looked at that way, you have a very simple Quality-Value-Momentum screen that anyone can put together with minimum fuss.

Yesterday I took a look at some of the Stockopedia screens that had low drawdowns and high returns. It was difficult to find a common pattern. The Naked Trader and Dremen low PE screen had quite complicated rules. They had debt components, as did WIG (Winning Income and Growth), an amazing screen.

On the other hand, the momo screens didn’t seem to care about debt. Tiny Titans and Value Momentum had no debt requirements. The Tiny Titans screen is breathtakingly simple: Price to Sales < 1, and relative strength over 1 year >0, in addition to a small market cap in the range £15m to £150m, and a spread less than 10%.

Investors should also consider whether extreme metrics are better than sufficient metrics. Gut instinct is to always search for the extreme, but that may not be such a wise move.

Stephen Bland’s PYAD Screen, for example, can be very demanding, and produce few results. Only 7 shares pass the screen currently, where the average is usually about 15. So perhaps we are not yet in a period where value is poised to have a strong run. If other readers think otherwise, then I would be genuinely interested to hear their reasoning.

Stephen’s screen has had big drawdowns: -27%, and an annualised return of 1.5%. Over 2 years it has lost 23%. I don’t think many people are going to be happy with that. I am not familiar with many of the companies that pass the screen, but there are two that I have a nodding familiarity with: JSI (Jiasen International Holdings) and HYNS (Haynes Publishing).

In Nov 2014, I said of JSI: “I have a number of problems with it as a company”. I should have called it an outright piece of Chinese AIM garbage. Shares have lost 88% over the last year, which to my mind vindicates my reservations about the company.

HYNS, which I am sure you are all familiar with, writes car manuals. It’s really been a long slow slide into irrelevancy for this company, so it’s all a bit touch-and-go. Maybe we’ll get a dead cat bounce, maybe we won’t. Answers on a postcard.

I also mentioned on my Twitter account about a site that I hadn’t visited in a long time: Stingy Investor. It is not a UK site, but it does have articles of general interest. It is very much influenced by Ben Graham mechanical investing strategies. The results are very impressive.

May you be happy, and may Santa bring you lots of nice presents.

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About mcturra2000

Computer programmer living in Scotland.
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