Benjamin Graham — Part Five: Benjamin Graham’s “Last Will & Testament”

This is part five of a ten-part series on the life and career of Benjamin Graham, the Godfather of value investing and the Dean of Wall Street. You can find the first part of the series at the link below.

1. Benjamin Graham — Part One: An Introduction To The Godfather Of Activism
2. Benjamin Graham — Part Two: The Graham–Newman Partnership
3. Benjamin Graham — Part Three: Looking For Bargains
4. Benjamin Graham — Part Four: GEICO And The End Of Graham–Newman

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Further reading: SocGen’s Deep Value Ben Graham Stocks For November

Benjamin Graham — Part five: Benjamin Graham’s “Last Will & Testament”

In part four of this series I looked at, what turned out to be the best investment of Benjamin Graham’s career, GEICO and the closure of the Graham–Newman Corporation. But Graham’s legacy didn’t fade with the end of the Graham–Newman Corporation. In fact, even after his investment company shut its doors, Graham remained a figurehead of the financial community.

Indeed, while much of Graham’s work was published while he was running Graham–Newman, it was refined in the years after he left the corporation. The Dean of Wall Street updated both The Intelligent Investor and Security Analysis several times before his death in 1976, gave multiple interviews and published several essays on the topic of value investing after he officially retired from money management. But perhaps Graham’s most significant contribution to value investing came after his death with the publication of what has become known as Graham’s “Last Will & Testament.”

Benjamin Graham and James Rea

Graham’s last will was developed with James Rea, who wrote to Graham after reading one of his articles in Barron’s titled, “Renaissance of Value.” Rea had been working on a stock selection methodology and after reading Graham’s article, discovered that his approach seemed similar to Graham’s. The two value investors then began a three-year working relationship during which they developed Graham and Rea’s ten criteria for selecting stocks. The criteria were backtested over a 50-year period.

Rea likened his method of picking stocks to that of selecting a milk cow. When choosing a milk cow, you ideally want a cow that gives lots of milk (earnings), but also will give more milk year over year (growth in earnings). Milk can be turned into cheese, and Rea would want a lot of cheese from his milk (a high dividend yield). This was a high reward cow. The risk was that the cow would stop producing milk, in which case degree of risk was how much you paid for the cow relative to what you could get for the “meat on its bones” (the liquidation value). Graham and Rea then worked with this analogy to come up with the ten rules for stock selection that are so well known today.

Here are the ten criteria in full. The first five are susceptible to changes in prices and earnings while the second five are not. Criteria number five through eight measure a company’s financial strength. A potential investment must meet two of these three criteria.

Benjamin Graham – First five

1. Earnings Yield: Rea and Graham used required that the earnings yield be at least twice the average AAA corporate bond yield.
2. Price Shrinkage: A stock should have a price-earnings ratio that is 60% below its previous two-year average high. (Graham initially was only interested in stocks that were down at least 50% from their previous high but Rea convinced him that it was illogical to require a company’s price be down 50% from its high when earnings were growing rapidly. Eventually, the two reached a compromise.)
3. Discount to Tangible Book Value: The stock’s price should be less than or equal to two-thirds of the tangible book value.
4. Dividend Yield: The dividend yield should be greater than or equal to two-thirds of the average AAA bond yield. Therefore, if the AAA bond yield is 5%, a stock must have a dividend yield of at least 3.35%.
5. Net Current Asset Value: The stock should be trading below its per share net current asset value (NCAV) or “net quick” asset value. NCAV = Current assets – current liabilities – long-term debt – preferred equity.

Second five

1. Current Ratio: Current ratio must be greater than or equal to two.
2. Debt to Equity: Total debt (total liabilities) must be less than the company’s net worth. Debt-to-equity ratio < one.
3. Debt to NCAV: total debt (total liabilities) be less than the net current asset value.
4. Earnings Growth: The company in question should have doubled earnings over the last ten years (7% annualized).
5. Earnings declines: No more than two declines in annual earnings over the last 10 years (defined as a year-over-year drop of 5% or more).

Some of these criteria were more important than others. For example, according to Graham’s research, conducted over a 50-year period, buying stocks with an earnings yield at least twice that of the AAA bond rate would have generated an annualized return of 19.9%; Buying stocks where the dividend yield was at least two-thirds the AAA bond yield would have generated an annualized return of 19.5%; and buying stocks with a price less than or equal to two-thirds of the tangible book value would have generated an average compounded growth rate of 14.2%. Over the same period, 1925 to 1975, the Dow Jones Industrial Average returned less than 8% per annum.

Benjamin Graham – Difficult to find

For Graham and Rea, there was more to selecting stocks than just screening for the above criteria. This is where Graham’s rules often become misinterpreted. Many value investors believe that just screening the market according to the above criteria will be enough to unearth bargains. But a strategy developed by the Dean of Wall Street was never going to be that simple.

Graham and Rea knew it would be difficult to find companies that would satisfy all ten criteria above (Société Générale points out that over the past 18 years only three companies have passed all ten criteria). As a result, the two partners developed a scoring scale.

The scale is simple. If a company meets a criterion it receives one point. There are a maximum of ten points available. It is also possible for a company to score half a point, although it’s not entirely clear what qualities a company had to exhibit to be awarded a half point. Only two explicit examples were given of what qualifies for a half point.

Dividend Yield: A whole point is awarded if the dividend yield is at least two-thirds that of the AAA bond yield. A half point is awarded if the dividend yield is between one-half and two-thirds of the AAA bond yield.

Earnings Growth: A whole point is awarded if the company has no more than two 5% or greater annual declines in earnings over the last 10 years. A half point is awarded if there are three declines of 5% or greater over the last ten years.

Benjamin Graham – Looking for bargains

When they’d developed their scoring system, Benjamin Graham, and James Rea started looking for bargains, and they started

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