A Portfolio selected using Graham’s techniques

In his book The Intelligent Investor (first published in 1949 and updated in three further editions the last of which was published in 1973), Benjamin Graham detailed his criteria for selecting common stocks.

While I don’t intend reproducing those criteria here, (anyone who is interested can buy or borrow the book), I did use Graham’s filters to screen every company and trust listed on the ASX and selected a portfolio (using 5 December 2008 data).

Graham never tried to deeply analyse the business in which a particular company was in or attempt to forecast its earnings/growth rate etc. As he states in The Intelligent Investor:

“… stock valuations are only dependable in exceptional cases. For most investors it would probably be best to assure themselves that they are getting good value for the prices they pay, and let it go at that.”

Later in that same book, he states:

“… those who emphasise protection are always especially concerned with the price of the issue at the time of the study. Their main effort is to assure themselves of a substantial margin of indicated present value above the market price – which margin could absorb unfavourable developments in the future. Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company’s long-run prospects as it is to be reasonable confident that the enterprise will get along.”

What Graham was concerned about was having a “margin of safety” between the price he paid and the intrinsic value of the company. He used measures like the price-earnings ratio, the price-to-book ratio, a sound track record, the payment of dividends over a long period of time, sufficient size of the company and long-term debt being less than current assets minus current liabilities as his filters.

Graham’s criteria are very stringent. For example, the requirement that long-term debt be less than current assets minus current liabilities excluded the vast majority of companies listed on the ASX at 5 December 2008. Of the remaining companies, many were eliminated based on Graham’s other filters.

What I was left with were only 10 companies. Three of those 10 companies were more or less illiquid. Those companies also had wafer-thin profit margins (even though they all had sales of more then $500m in the last annual reporting period – a measure that I used to filter out companies that were not of an adequate size). For these reasons those three companies were eliminated.

Seven companies are too few for adequate diversification so I added four more that didn’t meet Graham’s criteria but are sound businesses available at (what I think) are reasonable prices: ASX, Austereo, WA Newspapers and Milton Corporation:

Company	Price	No. of shares	Sector
Caltex	$6.18	14,710	Oil & gas
Harvey Norman	$2.35	38,685	Retailing
Soul Pattinson	$8.33	10,913	Diversified financial
Sims Metal	$11.74	7,744	Metals & mining
Flight Centre	$8.30	10,953	Consumer services
Hills Industries	$2.90	31,348	Capital goods
Beach Petroleum	$0.75	122,026	Oil & gas
ASX	$31.60	2,877	Diversified financial
Austereo	$1.11	82,271	Media
WA Newspapers	$4.70	19,342	Media
Milton Corporation	$14.02	6,484	Diversified financial

The portfolio value is $1m with $90,909 invested in each company.

While there are only 11 companies in the above list, they represent seven different sectors of the market (which is very important in terms of not being over-exposed to one or two sectors). And of course, someone with $1m to invest would not put all of it in the share market, it would be prudent to put 50% of it in the bank.

I know that practically none of those companies listed above have robust outlooks for 2009 (tell me which companies do), but that’s the whole point – you can only buy at sensible prices when pessimism pervades the market. At other times you are normally buying at too high a price.

You don’t need to be a genius to know that some of these companies are going to experience reasonably significant earnings declines in 2008-09 – but for the most part that would already appear to be reflected in the depressed share prices.

The portfolio has an average price-earnings ratio of 9.6 (sure to go up as earnings decline), an average dividend yield of 7.8% (sure to go down as earnings decline) and an average price-to-book-ratio of 1.92 (which is distorted upwards by WAN, a company with a grossly under-stated book value, without WAN this would be 1.07).

The portfolio earnings yield (100 divided by the price-earnings ratio) is 10.4% versus a rate of 4.28% (as I write this) for the 10 year Government bond – that would appear to be a very significant margin of safety.

Let’s see what happens over the next few years.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).