Ben Graham is considered to be the father of value investing and Warren Buffet's guru. His focus was on value stocks - companies that were trading far below the value of their assets. Graham said investors should analyse a company's financials and come up with intrinsic value and buy the company only when it's trading below the intrinsic value. The best stocks of this nature are those that trade at least one-third below their net current asset value (current assets minus liabilities).
1. In his analysis, Graham used earnings yield (which is the inverse of the P/E ratio) and the ratio of stockholders' equity to total assets.
2. Earnings yield, the first criterion, had to be at least twice that of what AAA-rated corporate bonds yielded. For an investor to venture into stocks, that should be the minimum rate of return.
3. The other criterion was based on the assumption that a company should own at least twice of what it owes. In other words, the ratio of shareholder equity to total assets should be a minimum of
50 per cent.
4. This mechanical stock selection called for holding a portfolio of 30 such stocks for a period of three years or till a 50 per cent gain is achieved, whichever occurred first.
5. How much could an investor applying this technique expect to gain? On the basis of extensive back-testing, dating back 50 years, Graham suggested that an investor following this strategy could have netted twice as much as the Dow Jones Industrial Average.
6. Additionally, all stocks had to have a maximum P/E of 10. Graham was against buying stocks above that premium.
Modified Graham filters for Indian markets
1. Earnings yield more than 1.5 times that of AAA corporate bond yield (7.25%)
2. Total debt less than half of book value (debt to equity less than 0.50)
3. Current ratio greater than 2
4. Total debt less than 2 times net current asset value (NCAV)
5. 5-year earnings growth rate of at least 10% CAGR
6. Current and average 5-year ROE of more than 12%