by The Graham Investor on May 7, 2011

M uch has been made of Benjamin Grahams so-called 10 Rules for selecting stocks. In his later years, having started to focus more on earnings and dividends than assets, Ben condensed his six decades of investing experience into ten apparently straightforward rules in order to help the intelligent investor select value stocks. The ten rules produced market-beating returns for five of the six decades that Ben tested it on. Later, limited, testing by Henry R. Oppenheimer from 1974 to 1981 showed that selecting stocks based on two or three of the 10 rules would have brought average annual returns of at least 26 percent. It is interesting to note that Oppenheimer used only 2 or 3 criteria, but not surprising as the rules are extremely onerous and cannot result in a significant number of picks. Lets review the ten rules here:

1. An earnings-to-price yield of twice the triple-A bond yield. The earnings yield is the reciprocal of the price earnings ratio.

2. A price/earnings ratio down to four-tenths of the highest average P/E ratio the stock reached in the most recent five years. (Average P/E ratio is the average stock price for a year divided by the earnings for that year.)
3. A dividend yield of two-thirds of the triple-A bond yield.
4. A stock price down to two-thirds of tangible book value per share.
5. A stock price down to two-thirds of net current asset value — current assets less total debt.
6. Total debt less than tangible book value.
7. Current ratio (current assets divided by current liabilities) of two or more.
8. Total debt equal or less than twice the net quick liquidation value as defined in No. 5.
9. Earnings growth over the most recent ten years of seven percent compounded—a doubling of earnings in a ten-year period.
10. Stability of growth in earnings—defined as no more than two declines of five percent or more in year-end earnings over the most recent ten years.

At least one of these rules is probably not significant today. For example: the requirement of A dividend yield of two-thirds of the triple-A bond yield; this may have been relevant in Grahams day but nowadays it is not as common for stocks to pay dividends and bond yields are frequently out of tune with stock market returns, that is to say the relationship between bond yields and dividend yields has likely been inexorably altered over the years.

Earnings growth, and Stability of Earnings are certainly to be considered, as is the Current Ratio. These are easy enough to determine. (Although not currently on our screens, these are items we are planning to add in the future.) Price below two-thirds of NCAV is found on our screens. Price down to two-thirds of tangible book is probably overkill but can be determined, as can Total debt vs tangible book and NCAV, although I prefer to just use the Debt to Equity Ratio.

Its interesting to note that Graham worked with an Aeronautical Engineer named James Rea on screening these types of stocks. They turned up very few, even back then. Soon after Graham died in 1976, Rea and his son (James Jr.) started a mutual fund American Diversified Global Value alas, it didnt do well at all. Who knows if it was the rules, or the management that was to blame?