The father of value investing offers six criteria for picking stocks to meet your investing goals
Investing doesn’t have to be complicated. I’ve built this blog on the idea that investing can actually be easy if you keep to a few stock market basics.
We don’t get into stock picking much but finding the best investments can be an opportunity to boost your profits from a diversified portfolio. Picking stocks doesn’t mean you have to spend all your free time digging into financial statements and tuning in to CNBC.
In fact, one of the best investors of all-time had just six criteria for picking stocks in a safe investing portfolio.
This article is the 14th in our chapter-by-chapter review of The Intelligent Investor. The book was first published in the early 50s by Benjamin Graham, widely-known as the father of value investing and a mentor to Warren Buffett.
I’m reading through the 2003 edition which includes the 1973 text from Graham and the updated commentary by Jason Zweig. Reading through Graham’s last edition, it’s amazing how relevant his commentary is for today’s investor.
The first half of the book focuses on investment concepts and broader goals. Now in the second half, we get to investing advice to analyze individual companies and pick stocks. Chapter 14 reveals six criteria that Graham recommends defensive investors use in stock picking.
Stock Picking for Dividends and Higher Returns
Graham’s checklist for picking stocks for the defensive investor revolves around finding companies with a long history of stability and paying out dividends. It’s this stability and dividends that is most critical for a defensive investor, the person that doesn’t want to worry about stocks and just wants a stress-free investing strategy.
There are some accounting and technical words in here but all are so common in investing that you’ll find them on any stock page in Yahoo Finance or in an online investing site.
- Adequate Size of the Enterprise – Graham suggests only investing in large companies, measured by annual sales or assets. Small companies are now considered those with market capitalization of less than $2 billion.
- Strong Financial Condition – Current assets, the cash and receivables that can be converted to cash quickly, should be twice as much as current liabilities. This means the company should have no trouble paying its near-term debts over the next year.
- Earnings over 10 Years – Positive net income in every quarter over the last ten years.
- Long Record of Dividends – At least 20 years of paying a dividend. This is one that I have a problem with, noted below, and think you can still find excellent companies outside of this requirement.
- Growing Profits – Earnings growth of at least a third over ten year’s time.
- Value – Price should be no more than 15 times the average year’s earnings over last three years and no more than 1.5 times the company’s book value.
Graham goes beyond the stock picking screen and specifically looks at investments in utility companies, financial services and railroads. The advice lines up extremely closely with the investments you find in Warren Buffett’s investments at Berkshire Hathaway.
I’m not questioning Buffett’s investment ability or Graham’s advice but I think even the defensive investor needs to look outside these three sectors for stocks. While these three groups of stocks may have been filled with stable companies in the past, it isn’t the case today. Regulation and tech progress has made it a very different world for these three groups of stocks than existed just 20 years ago.
It goes to confirm the need for investors to put their money in all the sectors instead of just a few that are considered ‘defensive’ during the current market. That means picking stocks across all nine sectors as well as investing in funds that can give you diversified exposure.
- Consumer Staples are companies that sell consumer goods that people need even during a recession like food.
- Consumer Discretionary are companies that sell less necessary goods like alcohol and apparel.
- Technology includes old tech giants like Microsoft as well as newer upstarts
- Utilities run the range from electricity, water and alternative energy providers
- Materials are companies that sell basic resources used as inputs to production
- Healthcare companies include drugmakers and service providers
- Financials are everything from banks to investment firms and real estate companies
- Energy companies include explorers & drillers, distribution and refiners
- Industrials cover a wide range of companies from aerospace & defense, capital machinery, airlines and others
I recently highlighted one of my favorite ways to find investing ideas on Motif Investing. You can use the online investing site to find stocks in different sectors and then use Graham’s criteria to narrow your list.
Building your Own Criteria for Picking Stocks
Graham’s stock picking criteria are a good start but you need to take them a little further.
First, whatever criteria you go with to pick stocks, you need to use them individually in each sector. Comparing stocks on criteria across all sectors at the same time is going to bias your portfolio to companies in just a few industries. That’s very risky because your investments will jump and plunge when something happens to those industries.
Getting this diversification in companies of different sectors is the only way to win the stock market game, by reducing your risk and focusing on your investing goals.
I also would adjust some of Graham’s stock picking requirements. I love dividends just as much as the next investor but requiring 20-years of dividend history is going to close your portfolio off to a lot of great companies. Apple just restarted its dividend in 2012 and most companies in tech didn’t even exist 20 years ago.
Graham comes off his strict price-to-earnings requirement of no more than 15 times later in the chapter and says that investors may look at companies with a P/E that is 20% lower than the earnings yield equivalent on the 10-year AA corporate bonds.
Ok, that may be a little confusing so let’s work through it.
- The earnings yield is just the upside-down of the P/E so it is earnings divided by price. For AA-rated corporate bonds, just one notch below the best rating, the yield is 2.7% currently. That’s how much bonds of strong companies are ‘earning’ over their price.
- If we take 1 divided by the bond’s yield of 2.7% then we get 37.0 for a starting price-to-earnings ratio.
- Multiplying 37.0 times 0.80 gives us 29.6 as a price-to-earnings that is 20% below the equivalent earnings yield.
It’s a good way to adjust your measure of a ‘value’ stock for the current stock market. While I think the previous 15-times P/E maximum is too low…I also think this new 29.6-times value is too high.
Bond rates have been beaten down artificially by massive central bank stimulus programs since the 2009 crisis and interest rates are ridiculously low. In many parts of the world, people are actually paying governments to hold their money, i.e. negative interest rates on government bonds.
Again, keeping just one maximum P/E limit on what you will pay for a stock is only going to create problems. You will end up over-investing in a few sectors that have lower P/E averages because growth is slower.
Instead, use a different max price-to-earnings value for each sector in which you invest. I know, it’s more work but there are only nine sectors so not too much work. Find the average price-to-earnings of companies in each sector from Morningstar or through your online broker and then limit your stock picks to those with a 20% discount to that average.
Nobody should rely on stock picking for their entire portfolio. Even active investors are going to find the time required to manage a portfolio of individual stocks just too much. Instead, use what’s called the core-satellite investing strategy to reduce your risk but still get higher returns on stock picking.
The core part of your portfolio, up to 70% of your money, is invested in broad funds that hold many stocks. This reduces your risk around any particular company. You can then use the rest of your money, the 30% satellite portion, to invest in individual stocks for higher returns.
Grab your copy of The Intelligent Investor on Amazon and follow along with the review.
Picking stocks doesn’t mean you need to trade in and out frequently. Use the stock picking criteria to find great companies that return cash to shareholders, then hold them for decades. Adjust the criteria around your own needs and invest broadly across sectors for a diversified portfolio of stocks that can meet your financial goals.