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by Henry R. Oppenheimer

A T e s t o f D e n Graham's S t o c kSelection Criteria

Benjamin Grahambelieved in the overall efficiency of securities markets, but healso believed that any conscientious investor could map a high trail through theslough of marketefficiency by paying close attention to investment fundamentalsand taking advantage of undervaluation and mispricing of individual securities.Among the maps he bequeathed to investors was a list of 10 criteria or identifyingundervalued stocks.Theauthor screened New Yorkand American StockExchangesecuritiesto selectthose issues that met various sets of Graham'scriteriaand measuredperformancesof portfolios formed from those issues over the years 1974through 1981. Over thatperiod, the CRSP ndex of NYSE-AMEX ecuritiesprovided a mean annual return(including dividends) of 14 per cent. An investor who had used Graham'sadviceto select from the NYSE-AMEXuniverse securities of firms with an earnings-to-price ratio at least twice the AAA bond yield and total debt less than book valuewould have achieved a mean annual return of 38 per cent!Although the superior performance of the portfolios created from Graham'sselection criteriadeclined after1976,the year the criteriawere published, it did notdisappear. Furthermore, excess returns remained after risk adjustment andadjustment for firm size effects."Ican assure the reader that among the 500-odd NYSE issues selling below seven timesearnings today, there are plenty to be foundfor which the prices are not 'correct'ones, inany meaningful sense of the term. They areclearly worth more than current sellingprices,and any security analystworth his saltshould be able to make up an attractiveport-folio out of this 'universe.' "'

HUS BENJAMINGRAHAM argued inthe pages of this journal in 1974 that,while markets were efficient overall,pockets of inefficiencyexisted. He believed thatopportunities for mispricing where most likelyin the smaller, less analyzed issues. He be-

lieved, further, thatinvestors'emotionalswingscould cause "centralvalues" to depart signifi-cantlyfromsecurityprices. And he listed, in anarticle published in Forbes shortly after hisdeath, the criteria nvestors could use to locatesuch inefficiencies.2This article examines theefficacy of those criteria.3The StudyTableI lists Graham's 10 criteria.GrahamandRea suggested that the first five measure "re-ward"and the second five "risk."To be eligiblefor a portfolio,a securitymust meet at least onerewardcriterionand one risk criterion.Grahampredicatedhis advice on the belief that a securi-ty's value and subsequent performancedependon acceptableoperating performanceand a sol-id (conservative) financial condition.Totest the criteria,Iused a naive strategythatassumed an investor purchased securities

1. Footnotes appear at end of articleHenryOppenheimers AssistantProfessorf Finance t theM. J.NeeleySchool f Business f TexasChristianUniver-sity.

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Table II Number of FirmsMeetingSpecificScreens(1) & (6) (3) & (6) (1), (3) & (6) (1), (6) & (9) (1), (3), (6) & (9)Criteria NYSE AMEX NYSE AMEX NYSE AMEX NYSE AMEX NYSE AMEX

ScreenDate12/311973 113 123 128 66 78 48 21 28 11 51974 183 124 172 93 117 64 49 34 24 141975 54 83 101 60 17 25 18 26 5 71976 45' 67 59 37 10 15 10 17 1 41977 53 58 96 36 17 11 16 25 4 61978 61 42 82 28 29 10 23 21 9 61979 33 15 38 11 9 2 20 12 4 21980 2 3 9 5 0 0 ---

TableI BenjaminGraham'sStock Selection Criteria(1) An earnings-to-price ield at least twice the AAAbond yield.(2) A price-earnings atio less than 40 per cent of thehighest price-earnings atio the stock had over thepast five years.(3) A dividendyield of at least two-thirds the AAA bondyield.(4) Stockpricebelow two-thirdsof tangiblebook valueper share.(5) Stockpricebelow two-thirds "net currentassetvalue."(6) Totaldebt less than book value.(7) Currentratiogreaterthan two.(8) Total debt less than twice "net currentasset value."(9) Earningsgrowth of prior 10years at least at a 7 percent annual (compound)rate.(10) Stabilityof growth of earningsin that no more than

two declines of 5 per cent or morein year-endearnings n the prior10years are permissible.Source:P. Blustein, "Ben Graham's Last Will and Testament,"Forbes,August 1, 1977, pp. 43-45.simultaneously meeting two or more criteria.Initialtests were run separately on criteria (1)and (6), (3) and (6) and (1), (3) and (6).4 Iassumed that the naive investor limitedhimselfto securitiestraded on an organized exchange.The Compusat Industrial and Research tapeswere screened for all New York StockExchange(NYSE)and American StockExchange (AMEX)securitiesmeeting any of the three sets of crite-ria on December 31 of each year between 1973and 1980.TableIIlists the number of securitieson each exchange that qualified.Foreach screenof each exchange, I selected atrandom35 securities(when possible)in propor-tion to their appearance in portfoliosof eligiblesecurities.5Equallyweighted portfolios of thesesecuritieswere purchased on the last businessday of March in the year following the screen.

Eachsecurity was held, accordingto Graham'sadvice, for either two years or until 50 per centprice appreciation occurred-whichever camefirst.Theperformancesof the portfolioswere eval-uatedusing standardmethods. I used the CRSPtapes to obtain mean monthly returns for thesecuritiesand the market.I also calculatedrisk-adjusted returns, as follows:

Rit - Rft = ai + i (Rmt - Rft) + eit'where:

Rit = the month t (t = 1, . . , 24) returnearned by a security meeting thescreening criteria and purchased inmonth 0;Rft= the "risk-free"(Treasurybill) rate ofreturnin month t;Rmt= the rate of return on the market portfo-lio (the CRSPvalue-weightedportfolioof NYSEand AMEXstocks);

,8i = cov(Rit, Rmt)I&o(Rmt),or security i's riskrelativeto the marketportfolio;eit = an error term assumed to have expect-ed value of zero and to be seriallyuncorrelated;andai = a measure of monthly abnormalper-formancefor the security evaluated.The equationmerely says that realizedsecurityreturnin excess of the risk-freerate is a linearfunction of threeterms-a premiumforbearingrisk(namely,the product of a security's risk andthe market's return in excess of the risk-freerate), a random errorterm with expected valueof zero, and an estimate of a security's perform-ance not accounted for by either market return

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Table VI A Comparisonof the Screens with the AppropriateReinganumMVPortfoliosA. Return Comparisons

NYSESecuritiesYearsHeld MV7 (1)& (6) (3)& (6) (1), (3) & (6)

1974-75 9.3% 72.6% 58.2% 81.3%1975-76 126.4 383.9 242.2 330.41976-77 65.9 188.3 86.9 292.31977-78 30.3 70.6 11.4 37.01978-79 62.5 90.0 48.5 70.61979-80 88.1 91.8 62.4 56.41980 33.0 41.9 19.1 17.6

AverageMedian Size 119.1 115.9 114.9 102.7AMEXSecurities

MV2 (1)& (6) (3)& (6) (1), (3) & (6)1974-75 27.5% 52.7% 44.0% 48.5%1975-76 150.4 940.1 167.2 156.91976-77 88.6 210.0 84.7 95.81977-78 59.3 83.0 31.6 49.91978-79 88.7 96.3 90.0 185.01979-80 91.0 155.7 103.3 129.41980 29.8 52.0 32.4AverageMedianSize 10.8 11.6 16.1 15.4

B. Risk ComparisonsNYSESecurities

MV7 (1) & (6) (3)& (6) (1), (3) & (6)High Beta 1.23 1.16 1.12Mean Beta 1.28 0.94 0.93 0.88Low Beta 0.37 0.60 0.67

AMEXSecuritiesMV2 (1)& (6) (3) & (6) (1), (3) & (6)

High Beta 1.46 1.07 1.11MeanBeta 1.57 1.10 0.77 0.89Low Beta 0.63 0.31 0.41

risk-adjustedreturnresults; foreach set of crite-ria, there are economically largeexcess returns.Table V shows the results for the combinedexchange screens. The CRSPNYSE-AMEXn-dex provided a mean annual return (includingdividends) of 14 per cent over the test period.By using Graham'scriteria (1) and (6) to selectsecurities fromthe combined NYSE-AMEX ni-verse, an investor could have achieved a meanannual returnof 38 per cent! Use of criteria(3)and (6) and (1), (3) and (6)would have resultedin mean annualreturnsof 26 per cent and 29 percent, respectively.9Although the superior per-formance of the portfolios created from theselection criteriadeclined after 1976, it did notdisappear.Furthermore,the performance doesnot appear to be due either to systematicrisk orto size effects.

An Alternative Approach to SizeIn a study of the small firm effect, Reinganumdivided all NYSE and AMEX securities intodeciles according to firms' market capitaliza-tions for the year 1963-80 and found that thetwo deciles with the smallest firms (MV1 andMV2) had significant positive excess returns,whereas the remaining deciles had negativeexcess returns.0 I compared the two-yearhold-ing period returns of each of the portfoliosformed using Graham's criteria with returnsfrom Reinganum's portfolios of comparablysized firms.TableVI compares the GrahamNYSEsecuri-ties with the seventh decile (MV7)of Reingan-um's NYSE-AMEX opulationand the GrahamAMEX securities with Reinganum's secondsmallest decile (MV2).The results are similartoFINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 984 O 72

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Table VII Performance Measures for the Screens Including Historical Earnings Growth (including all firms in Tables III and IV)

Mean MedianFirm Firm Raw Returns Risk-Adjusted Measures Risk and Size-Adjusted MeasuresSize SizeHolding (millionsof RAi Rmt e b ^ t5 b 2Period dollars) (%monthly) & %) t(a) 03 t() R2 &(%) t(i)b / t(,B) (x 1000) t(5)b R24/74-3/76 226.0 26.7 2.47 0.94 1.58 2.96* 1.32 17.60 0.309 4.73 1.57 1.32 17.58 -0.71 -1.06 0.310

Ol5 4/75-3/77 921.0 46.8 2.91 1.23 1.02 2.03** 1.16 10.92 0.194 1.34 0.51 1.16 10.91 -0.07 -0.12 0.1944/76-3/78 141.8 36.6 1.75 0.05 1.54 4.15*** 0.74 5.63 0.049 6.56 2.43** 0.74 5.60 -1.08 -1.87* 0.055s 4/77-3/79 39.0 21.5 2.90 0.83 2.25 4.86*** 1.21 9.82 0.185 7.01 1.63 1.21 9.83 -1.10 -1.11 0.187) 4/78-3/80 1,053.0 65.5 3.44 1.24 1.37 2.85*** 1.34 13.53 0.275 6.86 2.69*** 1.34 13.50 -1.14 -2.19** 0.2824/79-3/81 202.6 24.9 3.03 1.92 0.99 2.27** 1.13 12.32 0.230 1.24 0.47 1.13 12.31 -0.05 -0.10 0.2304/80-12/81 673.5 109.6 4.33 1.50 1.93 3.17*** 0.78 5.72 0.089 6.94 2.03** 0.78 5.76 -0.90 -1.44 0.095

o 4174-3/76 533.2 53.1 2.45 0.94 1.65 2.38** 1.00 10.31 0.258 4.08 1.02 1.00 10.30 - 0.51 - 0.62 0.2594/75-3/77 920.4 117.1 3.18 1.23 1.48 3.96*** 0.98 12.78 0.226 8.85 3.15*** 0.96 12.20 -1.41 -2.65*** 0.236* 4/76-3/78 138.7 56.3 1.63 0.05 1.45 3.05*** 0.77 4.69 0.091 17.30 3.36*** 0.76 4.69 -3.27 -3.09*** 0.129

.Z ". 4177-3/79 29.1 25.2 2.96 0.83 2.42 2.16** 1.11 3.76 0.159 11.50 0.70 1.12 3.77 -2.07 -0.55 0.162U _ 4/78-3/80 3,122.9 102.4 3.30 1.24 1.43 2.17** 1.10 7.92 0.295 7.34 2.68X** 1.09 7.91 -1.15 -2.22** 0.317C Cf) 4/79-3/81 169.5 104.5 2.38 1.92 0.64 1.11 0.85 7.16 0.164 1.72 0.43 0.85 7.14 -0.22 -0.27 0.161~ 4/80-12/81 1,126.9 96.4 3.54 1.50 1.55 1.54 0.61 2.72 0.088 -4.66 -0.96 0.54 2.38 1.30 1.30 0.108

Significant at 10 per cent level.* Significant at 5 per cent level.Significant at 1 per cent level.

those presented earlier. For the NYSE securi-ties, portfolios formed from screens of criteria(1) and (6) outperformed the comparablysizedportfolios in each period; portfolios formedfrom screens of criteria (3) and (6) and criteria(1), (3) and (6) outperformed the comparablysized portfolios prior to publicationbut not afterpublication.Forthe AMEXsecurities,portfoliosformed from each screen generally outper-formed the portfolios of firms of comparablesize both beforeand afterpublication.Giventhelarge differences in the betas of the screenedportfoliosand Reinganum'scomparisonportfo-lios, it would appear that the excess returnsdorepresent selectivity effects of the criteria,ratherthan size effects.

The Value of Additional CriteriaCan one increase returns by including addi-tional criteria?The results presented in TablesIIIthrough VI suggest that adding criterion (3)to criteria 1) and (6)resulted in decreasedeturn.I nevertheless tested each security satisfyingcriterion(9) in addition to the sets of criteria 1)and (6) and (1), (3) and (6).The number of securities meeting the new,more stringent, screens is included in Table II.TableVIIpresents the results. A directcompari-son of Table VII with PanelsA and C of Table Vindicates that each screen including criterion 9)provided a small increment in both raw andrisk-adjustedperformance."Inconclusion,the evidence suggests thatGra-ham's advice was not without merit. It has

providedfor significant,excess returns. UFootnotes1. Benjamin Graham, "The Future of CommonStocks," FinancialAnalystsJournal,September/October1974,p. 232. See P. Blustein, "Ben Graham's Last Will andTestament,"Forbes,August 1, 1977, pp. 43-45.For a more detailed exposition of the develop-ment of these criteria,see J. Rea, "RememberinrgBenjaminGraham-Teacher andFriend,"JournalofPortfolioManagement, all1977,pp. 16-27.3. Oppenheimerand Schlarbaumhave provided exante tests of the criteriain Graham'sIntelligentInvestor.See H. Oppenheimer and G. Schlar-baum, "Investingwith Ben Graham:An ExAnteTestof the EfficientMarketsHypothesis,"Journalof Financial nd QuantitativeAnalysis,September1981, pp. 341-360 and H. Oppenheimer and G.Schlarbaum, "Investment Policies of PensionPlans and Property-Liabilitynsurers:A LessonfromBen Graham,"Journal fRiskandInsurance,December1983,pp. 611-630. Graham'sadvice tothe "defensiveinvestor"of Intelligentnvestorwasintended to result in purchase of largeconserva-tive companiesand to provide an average (mar-ket) return. Despite that, Oppenheimer andSchlarbaumound that simulatedportfoliospro-vided significantpositive excess returnsover the1955-76 period.An earlierversion of the present article, em-phasizing firm size effects, is available from theauthar.4. These three screens are suggested as being themost useful (andprofitable)n the Blusteinarticleand are, perhaps, therefore most apt to be used

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by a naive investor. Furthermore, the thirdscreen has the virtue of providing evidence onthe value of adding another criterion.A fourthscreen-the net asset value criterion-is alsostronglyrecommendedand, indeed, the criterionGrahamwas famousfor.A separate nvestigationof it is currently n progress.5. Whereless than 35 (but more than eight) securi-ties were available, all eligible securities wereevaluated.6. This measurewas first introducedby M. Jensenin "The Performanceof Mutual Funds in thePeriod 1945-1964," TheJournal f Finance,May1968,pp. 389-416.7. Thus, for a screen of December 31, 1977, pur-chase was March 31, 1978 and sale March 31,1980.Note that the CRSPdata tapes used endedDecember31, 1981. Thus the 1979 screens haveonly 21 months and the 1980 screens only ninemonths of data.8. Thelogioof firm marketcapitalizationwas addedto separatesize and selectivityeffects.The use ofa separate size term is suggested by M. Rein-ganum in "A Direct Test of Roll'sConjectureonthe Firm Size Effect," Journal f Finance,March1982, pp. 27-36.9. In comparison,Blusteinprovides a summaryofthe returns that would have been availablebe-tween 1925and 1975, the period of historicaldata

Graham used to develop his criteria. Blusteinreports that for screens of criteria 1)and (6) and(3) and (6) average annual compound returns(excluding dividends and commissions) amount-ed to 19 and 18.5 per cent, respectively, versus anaverageannual returnof 3.5 per cent for the DowJones industrial average.10. See M. Reinganum, "AbnormalReturns n SmallFirm Portfolios," Financial Analysts Journal,March/April 981, pp. 52-56 and M. Reinganum,"PortfolioStrategiesBased on MarketCapitaliza-tion," Journal of PortfolioManagement,Winter1983, pp. 29-36.11. For the analyses relying on estimation of theequation, the R-squared s fairly low, comparedwith the earlier Oppenheimer and Schlarbaumwork. Utilization of the size variable did notincrease R-squared significantly. The majorrea-son for the low values appears to be the largenumber of large monthly security returnobserva-tions. Forthe screens of criteria 1) and (6), 12.2

per cent of the market observations of returnwere greater han 6 per cent, whereas 30percentof the firm observations were greaterthan 6 percent. This large disparity is likely caused by thefact that about 8 per cent of these firms wereacquired during the simulated holding periodwhile another 7 per cent were acquired duringthe two years subsequent to the holding period.

Earnings Expectationsconcludedfrompage 38lent to an average monthly compound rate ofreturn of 4.36 per cent. Thus, given an initialinvestment of $100, the portfolio's trendlineval-ue would be $104.36after one month and $108.91after two months. The actual value of the portfo-lio afterone month, however, was $110.50, or 5.9per cent above trendline. After two months theactual value was $106.90, or 1.9 per cent belowtrendline. Based on returns over a 12-monthperiod, one can obtain 11 monthly observationsof this type, because the beginning and endingvalues of the portfolio are coincident with thebeginningand ending values on the trendline aswe have defined it. The meanabsolute deviationover a one-year period is then found by calculat-ing the absoluteaverage of the 11 interim-month-ly deviationsderived in the above manner.9. Basedon a simulation nvolving 35.2 milliontrialsin which there were only seven occasionswherethe mean of 24 drawings (from 24 samplingpopulations that contained the numbers onethrough 1,000) was greaterthan 783. Thehighestsample mean was 802.10. Fromthe Fall1974 ssue of TheJournal fPortfolioManagement.

BALTIMOREAS NDELECTRICOMPANYDIVIDENDS INCREASEDON COMMON STOCK

Dividends have been declared for the quar-ter ending September 30, 1984 at the follow-ing rates per share:Common Stock-80 cents (previously 75cents).Preferred and Preference Stock-at thespecified rates.All are payable October 1, 1984 to holdersof record at the close of business on Septem-ber 10, 1984.

B.C. TRUESCHLERChairman of the Board

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