The Redacted Ben Graham

There is a set of rules, set forth by the great value investor Ben Graham and his colleague James Rea, that comes as close to guaranteeing success as you could expect. If you can find stocks adhering to the Graham-Rea rules, buy ... and buy in bulk. The rules are as follows:

1. An earnings-to-price yield of twice the triple-A bond. (If the triple-A bond is yielding 5.5%, the required earnings yield is 11%, or a price/earnings multiple of 9.1 or less.)
2. A P/E ratio down to four-tenths of the highest average P/E ratio the stock attained in the most recent five years.
3. A dividend yield of two-thirds the triple-A bond yield (or 3.67% today).
4. A stock price down to two-thirds of tangible book value per share.
5. A stock price down to two-thirds of net current asset value. (Current assets less total liabilities.)
6. Total debt less than tangible book value.
7. Current ratio (current assets divided by current liabilities) of two or more.
8. Total debt equal or less than twice the net quick liquidation value as defined in rule five.
9. Earnings growth of 7% compounded over the past 10 years (or a doubling of earnings over the past 10 years).
10. No more than two years of declining earnings of 5% or more over the past 10 years.

If you're wary of buying in bulk, don't be; you're not going to buy in bulk. In fact, you're not going to buy at all, because stocks matching all 10 criteria are as rare as Washington Generals victories over the Harlem Globetrotters.

Why it won't work
Times change, and Graham's balance-sheet-centric notion of buying stock in firms where the intrinsic value of the assets far exceeds the market capitalization worked well in the depths of the Great Depression, when investors were averse to holding equity. Back in the days of ledger paper, mechanical adding machines, and thick Standard & Poor's manuals, Graham could find companies whose liquidation value offered a substantial "margin of safety."

Book value has become less useful in modernity. Persistent inflation means the historical cost of assets can bear only passing resemblance to their actual worth. Meanwhile, firms extract more and more of their value from intangible assets, like intellectual property or brands, that don't show up in the financial statements. Coca-Cola (NYSE:KO), for example, gets much of its value not from physical equipment but from an indelible brand name built on relentless advertising.

Markets are also more efficient. Much of Graham's work was of the grinding number-crunching variety. Graham vetted company reports and painstakingly added and subtracted the numbers to determine a company's intrinsic value. Such effort would seem to offer no competitive advantage in today's information-saturated, microprocessed market.

Why it can work
Nevertheless, computers and databases -- albeit primitive compared to today's standards -- were available in later years to pick off Graham's low-hanging fruit, and they failed to pick them all. From 1974 to 1976, Graham manually researched the value of the 10 criteria to see what would have happened if an investor had employed them from 1925 to 1975. Graham's research found that the average stock selected using criterion 1 (low P/E ratio) and criterion 6 (with total debt less than market value of equity instead of book value) appreciated at an average annual rate of nearly 19% compounded (excluding dividends and commissions). The combination of criterion 3 (dividends) with criterion 6 worked nearly as well: 18.5%.

Graham's research suggests that an investor, using the three or four most important measures, can achieve success. Those four are criteria 1, 3, 5, and 6.

I screened using the simple criteria 1, 3, and 6 -- low P/E ratio, manageable debt, and investor cash flow -- and trailing data used in any free screening. I eliminated royalty trust companies -- real estate, oil, mortgage, or otherwise -- because most are simply pass-through entities where little value is added. A few names remained (or were pretty close), and, oddly enough, I find them appealing to my value-centric sensibilities.

You would think picking stocks based on such pedestrian, populist criteria would prove fruitless given the competition and everyone's access to the same information. Then again, perhaps successful investing is simply a matter of performing simple things well and using public knowledge intelligently. (To quote John Maynard Keynes: "The dealers on Wall Street could make huge fortunes if only they had no inside information.") Maybe that's the real secret behind the Ben Graham method of stock picking, and maybe his method can't be supplanted by technology, putative market efficiency, or time.