How to Pick Value Stocks like Benjamin Graham and Warren Buffett

Underlying Principles of Sound Investment for the Intelligent Investor

Chances are you know who Warren Buffett is.

If not, the very short version is that Buffett is the world’s most successful value investor.

The longer version is this: Warren Edward Buffett, born 89 years ago in Omaha, Nebraska, is the “Oracle of Omaha.” He grew up in Omaha and Washington, D.C. before attaining his bachelor’s and master’s degrees from the University of Nebraska and Columbia University. Mr. Buffett became interested in investing at an early age and attended Columbia in part because a pair of well-known securities analysts taught there.

Buffett then went to work for Buffett-Falk, his father’s brokerage company, before joining Graham-Newman for three years. Mr. Buffett then ventured out on his own and formed several investment partnerships, which purchased a company called Berkshire Hathaway, a textile manufacturing firm. In 1962, Buffett liquidated his partnerships to focus on Berkshire, and the rest is history.

Warren Buffett made one successful investment after another using Berkshire Hathaway (BRK-B) as his conduit. Buffett became adamant that his stocks provide a wide margin of safety. The intrinsic value of a company must outweigh the company’s stock price. He learned that strategy from one of his stock market-savvy Columbia professors, Benjamin Graham.

You might not be quite as familiar with that name. Let me familiarize you.

Who Is Benjamin Graham?

Benjamin Graham was born in London in 1894. (His original name was Grossbaum, but he changed it as a young man, the better to fit into the Wall Street environment.)

His parents moved to New York City when he was a year old. Graham was a brilliant student and won a scholarship to Columbia University. In 1914, he graduated second in his class, at age 20, and was invited to teach at the school. But he refused. His father had died, the family was poor, and Graham needed a larger income to support the family.

So he went to Wall Street and worked for the firm of Newburger, Henderson and Loeb for $12 per week.

His early duties included being a runner, delivering securities and checks, writing descriptions of bond issues, and later writing the firm’s daily market letter. Before long, he began to analyze companies, and at the age of 26 he was promoted to full partner.

In 1923, he left to set up his own partnership, and in 1928 he began teaching investment classes at Columbia. Over time, working with former student David Dodd, the lessons of his classes were gathered into his first book, titled Security Analysis, which was published in 1934.

The book has sold over a million copies. Warren Buffett says he’s read it at least four times. I’ve only read mine once (it’s the second edition, published in 1940, with 851 pages), but it remains a valuable reference. You can buy a fancy new leather-bound sixth edition on Amazon for $132. Or you can get a used one for $31. Or buy the Kindle electronic version for $42.53.

Or, you could simply read Graham’s second book, the more user-friendly The Intelligent Investor, which was published in 1949 and is less than half the size of its predecessor.

I recommend them both.

Benjamin Graham passed away in 1976 at the age of 82.

So what is it that made Graham’s work so special?

In short, he systematized the entire process of evaluating companies, all with the goal of finding low-risk (or no-risk) investments that would reward over the long run.

Graham liked to analyze and quantify a business according to six factors:

  1.  Profitability
    2.    Stability
    3.    Growth in earnings
    4.    Financial position
    5.    Dividends
    6.    Price history

More precisely, he required that a potential investment have the following:

  1.  An earnings-to-price yield at least twice the AAA bond yield
    2.    A P/E ratio less than 40% of the highest P/E ratio the stock had over the previous five years
    3.    A dividend yield of at least two-thirds the AAA bond yield
    4.    A stock price below two-thirds of tangible book value per share
    5.    A stock price below two-thirds of “net current asset value”
    6.    Total debt less than book value
    7.    Current ratio greater than two
    8.    Total debt less than twice “net current assets”
    9.    Annual earnings growth in the prior 10 years of at least 7% annual compounded
    10.   No more than two declines of 5% or more in year-end earnings in the prior 10 years

And this was all in the days before calculators! Granted, Graham was a whiz with a slide rule, and no doubt he did a lot of the calculations in his head. Nevertheless, that’s a lot of work.

But let’s simplify Graham’s strategy a bit, boiling it down to the seven criteria he used for picking value stocks.

How the Benjamin Graham Strategy Picks Value Stocks

The objective of Graham’s strategy is to identify unappreciated stocks and show you how to find undervalued stocks that meet certain criteria for quality and quantity … stocks that are poised for stellar price appreciation.

Here are Benjamin Graham’s seven time-tested criteria to identify strong value stocks:

Criteria #1:

Look for a quality rating that is average or better. You don’t need to find the best quality companies—average or better is fine. Benjamin Graham recommended using Standard & Poor’s rating system and required companies to have an S&P Earnings and Dividend Rating of B or better. The S&P rating system ranges from D to A+. Aim for stocks with ratings of B+ or better, just to be on the safe side.

Criteria #2:

Graham advised buying companies with Total Debt to Current Asset ratios of less than 1.10. In value investing, it is important at all times to invest in companies with a low debt load, especially now with tight lending in a lukewarm economy. Total Debt to Current Asset ratios can be found in data supplied by Standard & Poor’s, Value Line, and many other services.

Criteria #3:

Check the Current Ratio (current assets divided by current liabilities) to find companies with ratios over 1.50. This is a common ratio provided by many investment services and is especially important now, because you want to make sure a company has enough cash and other current assets to weather any further declines in the economy.

Criteria #4:

Criteria four is simple. Find companies with positive earnings per share growth during the past five years with no earnings deficits. Earnings need to be higher in the most recent year than five years ago. Avoiding companies with earnings deficits during the past five years will help you stay clear of high-risk companies.

Criteria #5:

Invest in companies with price to earnings (P/E) ratios of 9.0 or less. Look for companies that are selling at bargain prices. Finding companies with low P/Es usually eliminates high growth companies, which should be evaluated using growth investing techniques.

Criteria #6:

Find companies with price to book value (P/BV) ratios less than 1.20. P/E ratios, mentioned in criteria #5, can sometimes be misleading. P/BV ratios are calculated by dividing the current price by the most recent book value per share for a company. Book value provides a good indication of the underlying value of a company. Investing in stocks selling near or below their book value makes sense.

Criteria #7:

Invest in companies that are currently paying dividends. Investing in undervalued companies requires waiting for other investors to discover the bargains you have already found. Sometimes your wait period will be long and tedious, but if the company pays a decent dividend, you can sit back and collect dividends while you wait patiently for your stock to go from undervalued to overvalued.

One last thought. It’s helpful to find out why a stock is selling at a bargain price. Is the company competing in an industry that is dying? Is the company suffering from a setback caused by an unforeseen problem? The most important question, though, is whether the company’s problem is short-term or long-term, and whether management is aware of the problem and taking action to correct it. You can put your business acumen to work to determine if management has an adequate plan to solve the company’s current problems.

Benjamin Graham’s Mr. Market

One of Benjamin Graham’s favorite parables is that of Mr. Market, who Graham often referred to in his classes at Columbia as well as several times in his book, The Intelligent Investor.

Graham’s Mr. Market is a fellow who turns up every day at the stock holder’s door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn’t mind this, and will be back the following day to quote another price.

Graham’s point is that the investor should not regard the whims of Mr. Market as determining the value of the shares that the investor owns. He should profit from market folly rather than participate in it. The investor is best off concentrating on the real life performance of his companies and their dividends, rather than being too concerned with Mr. Market’s often irrational behavior.

Here’s an excerpt from The Intelligent Investor by Benjamin Graham, Revised Edition 2005, page 204-205:

“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

“If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful.

“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

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