Graham's Investment Strategy - The Simplest Way to Select Bargain Stocks
Benjamin Graham is a stock market expert who has unparalleled understanding of the stock market and actual stock value. He is regarded as a guru in the field of security analysis. Graham not only co-wrote a book called "Security Analysis" which was hailed as a business bible, but his record in selecting winning stocks is also legendary on Wall Street.
Graham retired to California at an early age of 35 with his millionaire status already established. In recent years, he has been devoted to simplifying the stock selection methods that have made him successful for half a century into several easy-to-follow principles. The 82-year-old Graham has recently collaborated with investment adviser James B. Rea to establish a fund whose investment policy will be based on these principles. Graham believes that doctors should be able to use these same principles to achieve an average annual return of 15% or more and manage their own investments.
Graham retired to California at an early age of 35 with his millionaire status already established. In recent years, he has been devoted to simplifying the stock selection methods that have made him successful for half a century into several easy-to-follow principles. The 82-year-old Graham has recently collaborated with investment adviser James B. Rea to establish a fund whose investment policy will be based on these principles. Graham believes that doctors should be able to use these same principles to achieve an average annual return of 15% or more and manage their own investments.
Sitting in his studies in La Jolla Beach apartment, Benjamin Graham outlined to Bart Sheridan, West Coast editor of Medical Economics, the basis of his method.
Key points:
1、Graham proposed a simple method of selecting undervalued stocks, using price-earnings ratio as a criterion and only choosing stocks with a P/E ratio lower than twice the average yield of AAA-rated corporate bonds.
2、Graham suggested considering a company's financial condition, especially the ratio of shareholder equity to total assets, to ensure that the companies in the investment portfolio have good financial conditions. Graham's research shows that this method has performed well in the long run and can be achieved through a widely diversified investment portfolio.
3、Graham advised investors to build broadly diversified investment portfolios with a holding period of two to three years, set a profit target of 50%, and be prepared for the possibility of short-term poor performance. Graham believes that in the long run, this method can achieve an average return of 15% or better. The key to success is consistently applying these standards over a sufficiently long period of time.
Q&A
Sheridan asked:
Can you tell us how to use the simplified Graham technique?
Graham replied:
Alright, for the past few years, I have been testing the results of selecting undervalued stocks based on several simple criteria. My research shows that an investment portfolio using this method has a long-term return on investment twice that of the Dow Jones Industrial Average. The study spanned 50 years, but the method has also proven successful in shorter periods of time. I am very impressed with this and I believe it should be put into practice.
Sheridan asked:
Does your technique seek growth problems?
Graham replied:
No. In my opinion, so-called growth stock investors - or average securities analysts - don't know how much they're paying for growth stocks, how many shares they need to get the required return, or how their prices will change. However, these are all fundamental issues. That's why I think the concept of growth stocks cannot be applied with relatively reliable results.
Sheridan asked:What about traditional measures of stock such as forecasts of earnings or market share?Graham replied:These factors are important in theory, but in practice, they are of little use in determining specific stock prices or when to sell. The only thing you can be sure of is that sometimes a large number of stocks are priced too high, and at other times, they are priced too low. My investigation leads me to believe that you can pre-determine the "buy" and "sell" levels of these logics for a widely diversified investment portfolio without involving basic factors that affect the prospects of specific companies or industries.
Sheridan asked:Ignoring fundamentals like this way of thinking-may be considered heretical by many analysts...
Graham replied:Perhaps, but my research shows that it does work. What is needed is first, a clear buying rule indicating that you are buying stocks at prices below their value. Second, you must use enough shares to make the method effective. Finally, you need a very clear selling guide.
Sheridan asked:Can doctors or any investors like me do this?
Graham replied:Absolutely.
Sheridan asked:
How do I get started?
Graham replied:By listing as many common stocks as possible whose latest (not projected) price is not more than seven times their current earnings listed in the stock price column of The Wall Street Journal or other leading daily newspapers.
Sheridan asked:
Why is it seven times P/E instead of, say, nine times or five times?
Graham replied:
One way to determine the stock price to be paid at any given time is to observe the yield on quality bonds. If bond yields are high, then you want to buy stocks cheaply, which means you will be looking for relatively low P/E ratios. If bond yields fall, you can pay more for the stock and accept higher P/E ratios. The empirical rule for pricing stocks in this way is that I only select those stocks whose dividend-price ratio (abbreviated as the inverse of P/E) is at least two times the current average yield of AAA-rated corporate bonds.
Sheridan asked:
Can you give me an example?
Graham replied:
Of course. Just double the bond yield and divide the result by 100. The average current yield of AAA bonds is slightly above 7% today. Multiplying by 2 gives you 14, and dividing 14 by 100 gives you about 7 times. Therefore, the highest price you would be willing to pay for a stock today when building an investment portfolio using my system should be seven times earnings. If a stock has a P/E ratio higher than seven times, it is not included.
Sheridan asked:
What if the AAA bond yield drops to 6%?
Graham replied:Then the acceptable P/E ratio will rise. Double six is twelve; divide twelve by 100, and you get a maximum P/E ratio of 8. However, I believe that stocks with a P/E ratio of more than 10 should not be purchased regardless of how much the bond yield drops. On the contrary, in my system, a P/E ratio of seven is always allowed regardless of the bond yield.
Sheridan asked:
Okay. So, as of today, your formula only applies to stocks with a P/E ratio of seven or less. Is that all?
Graham replied:Well, this combination alone is sufficient to provide a fairly good basis for an investment portfolio, but by using other criteria, you can do better. You should choose not only stocks that meet the P/E requirements, but also those in companies with satisfactory financial conditions.
Sheridan asked:
How do you determine this?
Graham replied:
You can apply various tests, but I like this simple rule: Companies should have at least twice as much equity as debt. Checking the ratio of shareholders' equity to total assets is a simple way to check this; If the ratio is at least 50%, the company can be
Sheridan asked:
Can you give me an example of how the rule would work?
Graham replied:Let's say a company has $30 million in shareholders' equity and $50 million in total assets, which is a 60% ratio. Because it's higher than 50, the company passes the test.
Sheridan asked:
Are there any stocks that meet this requirement and have a P/E ratio below seven?
Graham replied:Oh yes. There aren't as many as during the market downturns of 1973 and 1974, but there are still plenty.
Sheridan asked:
Once I've gone through the screening process and selected my "buy" candidates, how do I build the investment portfolio?
Graham replied:
To maximize your statistical chances, you need to trade as many stocks as possible. A portfolio of 30 stocks may be the ideal minimum. If your capital is limited, you can deal in "odd lots"-stocks of less than 100 shares.
Sheridan asked:
How long should I hold these stocks?
Graham replied:First, you set yourself a profit goal. A target of 50% of cost should work well.
Sheridan asked:
Do you mean I should aim for a 50% profit target for each stock I buy?
Graham replied:
No. You need to set an upper limit on the holding period of each stock in advance. My research shows that a holding period of two to three years works best. Therefore, I recommend following this rule: If the stock has not reached your target by the end of the second calendar year after purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you should sell it no later than the end of 1978.
Sheridan asked:
What should I do with the money once I sell the stocks? Reinvest in other stocks that meet your criteria?Graham replied:
Usually, yes, but you should be flexible depending on market conditions. For example, during a market downturn like in 1974, you will find good companies' stocks selling at low P-E levels, and you should take advantage of this situation by investing up to 75% of your investment capital in common stocks. Conversely, during periods of overall high pricing in the market, you will find it difficult to find stocks that meet my standards for reinvestment. At such times, you should invest no more than 25% of your funds in stocks, and the rest can be invested in US government bonds, etc.
Sheridan asked:
What kind of results can I expect using your strategy?
Graham replied:
Obviously, you cannot expect 50% returns on every stock you buy. If your holding period expires, you must sell at a smaller profit or even at a loss. But in the long run, you should average a return of 15% or better on your total investment, plus dividends and minus commissions. Overall, dividends should exceed commissions.
Sheridan asked:
Is this based on the returns you achieved over 50 years of your research?
Graham replied:Yes, and the results were very consistent over five consecutive years. I believe that shorter periods of time cannot fully prove the value of this strategy. When applying this method, every investor should be prepared financially and psychologically for the possibility of poor short-term performance. For example, investors lost money on paper during the recession of 1973-1974, but if they persisted and followed this method, they made up for their losses in 1975-1976 and averaged a return of 15% over five years. If we experience such a situation again, investors should be prepared to weather the downturns with patience.
Sheridan asked:
Is there a risk of a crash similar to the one that occurred after the overpriced market of the late 1960s and early 1970s when the Dow Jones index hit 1,000 points and many problems were at a five-year peak?
Graham replied:
I don't have any special confidence in myself or anyone else predicting what will happen in the market, but I know that if price levels are dangerously high, serious adjustments are likely to occur. In my tests, there have been many overpriced cycles, and the number of stocks available at discounted prices has been small; this warns that the entire market is priced too high.
Sheridan asked:
Can you summarize the key to making your method successful?
Graham replied:Investors need to use these simple criteria consistently over a long enough period of time to allow statistical probabilities to work. Patience is key.
Investment experiences of Graham
In 1915, Graham discovered an undervalued mining company and advised his friend to invest in it, resulting in a high return rate of 18.53%. However, he later suffered a heavy loss due to market manipulation and learned two lessons: not to trust insider information and to be wary of market manipulation.
Graham believed that speculation was not a good investment because it was based on rumors and carried high risks. He emphasized the importance of using effective techniques to avoid risks in the stock market. He designed a set of insurance plans using option trading to minimize risks and achieve potential profits.
In 1923, Graham founded the Graham-Newman Partnership and made profitable investments by analyzing the price differences between DuPont and General Motors. Although his investment fund eventually dissolved due to disagreements among shareholders, Graham met his ideal partner, Newman, who had exceptional management skills and allowed Graham to focus on securities analysis and investment strategies.
$Berkshire Hathaway-A(BRK.A.US$
Key points:
1、Graham proposed a simple method of selecting undervalued stocks, using price-earnings ratio as a criterion and only choosing stocks with a P/E ratio lower than twice the average yield of AAA-rated corporate bonds.
2、Graham suggested considering a company's financial condition, especially the ratio of shareholder equity to total assets, to ensure that the companies in the investment portfolio have good financial conditions. Graham's research shows that this method has performed well in the long run and can be achieved through a widely diversified investment portfolio.
3、Graham advised investors to build broadly diversified investment portfolios with a holding period of two to three years, set a profit target of 50%, and be prepared for the possibility of short-term poor performance. Graham believes that in the long run, this method can achieve an average return of 15% or better. The key to success is consistently applying these standards over a sufficiently long period of time.
Q&A
Sheridan asked:
Can you tell us how to use the simplified Graham technique?
Graham replied:
Alright, for the past few years, I have been testing the results of selecting undervalued stocks based on several simple criteria. My research shows that an investment portfolio using this method has a long-term return on investment twice that of the Dow Jones Industrial Average. The study spanned 50 years, but the method has also proven successful in shorter periods of time. I am very impressed with this and I believe it should be put into practice.
Sheridan asked:
Does your technique seek growth problems?
Graham replied:
No. In my opinion, so-called growth stock investors - or average securities analysts - don't know how much they're paying for growth stocks, how many shares they need to get the required return, or how their prices will change. However, these are all fundamental issues. That's why I think the concept of growth stocks cannot be applied with relatively reliable results.
Sheridan asked:What about traditional measures of stock such as forecasts of earnings or market share?Graham replied:These factors are important in theory, but in practice, they are of little use in determining specific stock prices or when to sell. The only thing you can be sure of is that sometimes a large number of stocks are priced too high, and at other times, they are priced too low. My investigation leads me to believe that you can pre-determine the "buy" and "sell" levels of these logics for a widely diversified investment portfolio without involving basic factors that affect the prospects of specific companies or industries.
Sheridan asked:Ignoring fundamentals like this way of thinking-may be considered heretical by many analysts...
Graham replied:Perhaps, but my research shows that it does work. What is needed is first, a clear buying rule indicating that you are buying stocks at prices below their value. Second, you must use enough shares to make the method effective. Finally, you need a very clear selling guide.
Sheridan asked:Can doctors or any investors like me do this?
Graham replied:Absolutely.
Sheridan asked:
How do I get started?
Graham replied:By listing as many common stocks as possible whose latest (not projected) price is not more than seven times their current earnings listed in the stock price column of The Wall Street Journal or other leading daily newspapers.
Sheridan asked:
Why is it seven times P/E instead of, say, nine times or five times?
Graham replied:
One way to determine the stock price to be paid at any given time is to observe the yield on quality bonds. If bond yields are high, then you want to buy stocks cheaply, which means you will be looking for relatively low P/E ratios. If bond yields fall, you can pay more for the stock and accept higher P/E ratios. The empirical rule for pricing stocks in this way is that I only select those stocks whose dividend-price ratio (abbreviated as the inverse of P/E) is at least two times the current average yield of AAA-rated corporate bonds.
Sheridan asked:
Can you give me an example?
Graham replied:
Of course. Just double the bond yield and divide the result by 100. The average current yield of AAA bonds is slightly above 7% today. Multiplying by 2 gives you 14, and dividing 14 by 100 gives you about 7 times. Therefore, the highest price you would be willing to pay for a stock today when building an investment portfolio using my system should be seven times earnings. If a stock has a P/E ratio higher than seven times, it is not included.
Sheridan asked:
What if the AAA bond yield drops to 6%?
Graham replied:Then the acceptable P/E ratio will rise. Double six is twelve; divide twelve by 100, and you get a maximum P/E ratio of 8. However, I believe that stocks with a P/E ratio of more than 10 should not be purchased regardless of how much the bond yield drops. On the contrary, in my system, a P/E ratio of seven is always allowed regardless of the bond yield.
Sheridan asked:
Okay. So, as of today, your formula only applies to stocks with a P/E ratio of seven or less. Is that all?
Graham replied:Well, this combination alone is sufficient to provide a fairly good basis for an investment portfolio, but by using other criteria, you can do better. You should choose not only stocks that meet the P/E requirements, but also those in companies with satisfactory financial conditions.
Sheridan asked:
How do you determine this?
Graham replied:
You can apply various tests, but I like this simple rule: Companies should have at least twice as much equity as debt. Checking the ratio of shareholders' equity to total assets is a simple way to check this; If the ratio is at least 50%, the company can be
Sheridan asked:
Can you give me an example of how the rule would work?
Graham replied:Let's say a company has $30 million in shareholders' equity and $50 million in total assets, which is a 60% ratio. Because it's higher than 50, the company passes the test.
Sheridan asked:
Are there any stocks that meet this requirement and have a P/E ratio below seven?
Graham replied:Oh yes. There aren't as many as during the market downturns of 1973 and 1974, but there are still plenty.
Sheridan asked:
Once I've gone through the screening process and selected my "buy" candidates, how do I build the investment portfolio?
Graham replied:
To maximize your statistical chances, you need to trade as many stocks as possible. A portfolio of 30 stocks may be the ideal minimum. If your capital is limited, you can deal in "odd lots"-stocks of less than 100 shares.
Sheridan asked:
How long should I hold these stocks?
Graham replied:First, you set yourself a profit goal. A target of 50% of cost should work well.
Sheridan asked:
Do you mean I should aim for a 50% profit target for each stock I buy?
Graham replied:
No. You need to set an upper limit on the holding period of each stock in advance. My research shows that a holding period of two to three years works best. Therefore, I recommend following this rule: If the stock has not reached your target by the end of the second calendar year after purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you should sell it no later than the end of 1978.
Sheridan asked:
What should I do with the money once I sell the stocks? Reinvest in other stocks that meet your criteria?Graham replied:
Usually, yes, but you should be flexible depending on market conditions. For example, during a market downturn like in 1974, you will find good companies' stocks selling at low P-E levels, and you should take advantage of this situation by investing up to 75% of your investment capital in common stocks. Conversely, during periods of overall high pricing in the market, you will find it difficult to find stocks that meet my standards for reinvestment. At such times, you should invest no more than 25% of your funds in stocks, and the rest can be invested in US government bonds, etc.
Sheridan asked:
What kind of results can I expect using your strategy?
Graham replied:
Obviously, you cannot expect 50% returns on every stock you buy. If your holding period expires, you must sell at a smaller profit or even at a loss. But in the long run, you should average a return of 15% or better on your total investment, plus dividends and minus commissions. Overall, dividends should exceed commissions.
Sheridan asked:
Is this based on the returns you achieved over 50 years of your research?
Graham replied:Yes, and the results were very consistent over five consecutive years. I believe that shorter periods of time cannot fully prove the value of this strategy. When applying this method, every investor should be prepared financially and psychologically for the possibility of poor short-term performance. For example, investors lost money on paper during the recession of 1973-1974, but if they persisted and followed this method, they made up for their losses in 1975-1976 and averaged a return of 15% over five years. If we experience such a situation again, investors should be prepared to weather the downturns with patience.
Sheridan asked:
Is there a risk of a crash similar to the one that occurred after the overpriced market of the late 1960s and early 1970s when the Dow Jones index hit 1,000 points and many problems were at a five-year peak?
Graham replied:
I don't have any special confidence in myself or anyone else predicting what will happen in the market, but I know that if price levels are dangerously high, serious adjustments are likely to occur. In my tests, there have been many overpriced cycles, and the number of stocks available at discounted prices has been small; this warns that the entire market is priced too high.
Sheridan asked:
Can you summarize the key to making your method successful?
Graham replied:Investors need to use these simple criteria consistently over a long enough period of time to allow statistical probabilities to work. Patience is key.
Investment experiences of Graham
In 1915, Graham discovered an undervalued mining company and advised his friend to invest in it, resulting in a high return rate of 18.53%. However, he later suffered a heavy loss due to market manipulation and learned two lessons: not to trust insider information and to be wary of market manipulation.
Graham believed that speculation was not a good investment because it was based on rumors and carried high risks. He emphasized the importance of using effective techniques to avoid risks in the stock market. He designed a set of insurance plans using option trading to minimize risks and achieve potential profits.
In 1923, Graham founded the Graham-Newman Partnership and made profitable investments by analyzing the price differences between DuPont and General Motors. Although his investment fund eventually dissolved due to disagreements among shareholders, Graham met his ideal partner, Newman, who had exceptional management skills and allowed Graham to focus on securities analysis and investment strategies.
$Berkshire Hathaway-A(BRK.A.US$
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