In Chapter 14 of Ben Graham’s classic text The Intelligent Investor he outlines and describes seven important stock screens for the defensive investor to consider. Graham advises the most conservative investor to hold only a portfolio divided among high-grade bonds and leading common stocks. The common stock portion of the portfolio could be chosen in two ways--buying the entire index (index fund today) or individual stocks which demonstrate the following seven qualities:

1. Adequate Size of the Enterprise

All our minimum figures must be arbitrary and especially in the matter of size required. Our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field. (There are often good possibilities in such enterprises but we do not consider them suited to the needs of the defensive investor.) Let us use round amounts: not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility. (Remember: Graham was writing these figures in 1973.)

2. A Sufficiently Strong Financial Condition

For industrial companies current assets should be at least twice current liabilities--a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or ’working capital’). For public utilities the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability

Some earnings for the common stock in each of the past ten years.

4. Dividend Record

Uninterrupted payments for at least the past 20 years.

5. Earnings Growth

A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price / Earnings Ratio

Current price should not be more than 15 times average earnings of the past three years.

7. Moderate Ratio of Price to Assets

Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 times. (This figure corresponds to 15 times earnings and 1.5 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)

General Comments:

These requirements are set up especially for the needs and the temperament of defensive investors. They will eliminate the great majority of common stocks as candidates for the portfolio, and in two opposite ways. On the one hand they will exclude companies that are (1) too small, (2) in relatively weak financial condition, (3) with a deficit stigma in their ten-year record, and (4) not having a long history of continuous dividends. Of these tests the most severe under recent financial conditions are those of financial strength. A considerable number of our large and formerly strongly entrenched enterprises have weakened their current ratio or overexpanded their debt, or both, in recent years (U.S. corporations in the early 1970s).

Our last two criteria are exclusive in the opposite direction, by demanding more earnings and more assets per dollar of price than the popular issues will supply. This is by no means the standard viewpoint of financial analysts; in fact most will insist that even conservative investors should be prepared to pay generous prices for stocks of the choice companies. We have expounded our contrary view above; it rests largely on the absence of an adequate factor of safety when too large a portion of the price must depend on ever-increasing earnings in the future. The reader will have to decide this important question for himself--after weighing the arguments on both sides.

We have nonetheless opted for the inclusion of a modest requirement for growth over the past decade. Without it the typical company would show retrogression, at least in terms of profit per dollar of invested capital. There is no reason for the defensive investor to include such companies--though if the price is low enough they could qualify as bargain opportunities.

To suggest maximum figure of 15 times earnings might well result in a typical portfolio with an average multiplier of, say, 12 to 13 times. Note that in February 1972 American Tel. & Tel. sold at 11 times its three-year (and current) earnings, and Standard Oil of California at less than 10 times latest earnings. Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/ price ratio--the reverse of the P/E ratio--at least as high as the current high-grade bond rate. This would mean a P/E ratio of higher than 13.3% against an AA bond yield of 7.5%.

Graham then goes on to provide data that suggests that about 100 of the S&P 500 stocks in 1970 would meet these seven screens... as he said, ’just about enough to provide the investor with a satisfactory range of personal choice.’

Credits: Credit for this article, and the ’intelligent’ pholosophy behind it goes to Ben Graham...a guiding light for Warren Buffett...the father of value investing.

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