8 Methods of Stock Picking: Value Investing Lessons from Benjamin Graham

8 Top Stock Picking Methods from Benjamin Graham

Stock Picking Method # 1: Deep Equity Research

  1. How: Series of comparative analyses industry by industry.
  2. What: Identify standard characteristics of an industry. Locate companies which deviate widely.
  3. Next: Study these more intensively (qualitative and quantitative factors).

Stock Picking Method # 2: Wide Stock Screening

  1. How: Quick glance at hundreds of snapshots.
  2. What: Pick 5 or 10 that look interesting enough from the earnings or current-asset standpoint.
  3. Next: Study these more intensively (qualitative and quantitative factors).

Stock Picking Method # 3: Superstar Stocks in Volatile Market Conditions

  1. Find normal level: 7 year average earnings of BSE Sensex or NSE Nifty * 2 * 1/bond rate.
  2. Buy: Start buying diversified portfolio at 20% discount. Scale till 33% discount.
  3. Sell: Start selling at 20% premium. Scale till 33% premium.

Stock Picking Method # 4: Unknown Stocks or with Poor Earnings Trend (in Normal Market Conditions)

  1. Look for high earnings (current & average) vs price or high net assets vs price + satisfactory earnings.
  2. Be alert & apply judgement to ensure at least average future prospects.
  3. Avoid during bull markets.

Stock Picking Method # 5: Unknown Stocks in All Market Conditions

  1. Hunt for grossly undervalued stocks at all times.

Stock Picking Method # 6: Spooked by Bad News

  1. Compare stock price decline vs. true damage from the bad news.

Stock Picking Method # 7: Dumped in Bankruptcy

  1. Find cases of protracted bankruptcy proceedings.
  2. Wait out the initial speculative period marked by high price compared to probable ultimate value.
  3. Determine approximately the best time for making a commitment in them. i.e. keep comparing price with intrinsic value.
  4. Don’t try to time to perfection. Being several months early is acceptable.

Stock Picking Method # 8: Arbitrage

  1. Relative prices of securities out of whack.
  2. Study the contractual relation.
  3. Consider exchange or hedging.

17 thoughts on “8 Top Stock Picking Methods from Benjamin Graham”

  1. When you say “Find normal level: 7 year average earnings of BSE Sensex or NSE Nifty * 2 * 1/bond rate”, what role does the 2 play in that?

  2. Yes I understand that. My questions is why? Why do you say that the ‘normal level’ is, in effect, the one where the earnings are capitalized at ‘half’ the yield on a risk free bond?

  3. 1. I don’t say so. Benjamin Graham does. Here’s the exact quote from Chapter 50, Security Analysis, 1940: “The multiplier might be equivalent to capitalizing the earnings at, say, twice the current interest rate on highest grade industrial bonds.”

    2. But of course, ‘the expert says so’ is not a good answer. The reason why he says so is because earnings from leading stocks (and we’re talking about stocks prominent enough to be included in Sensex or Nifty) have a growth component unlike bonds. This growing (hopefully!) stream of earnings must be capitalised at a higher multiple than a static stream of earnings. Graham uses 2 to arrive at this higher multiple.

    3. For a precise estimate of the multiple, the math is {1-(Growth Rate/ROE)}/(WACC – Growth Rate). Instead of doing all this, one can use 2/Rf like Graham suggests.

  4. I think he means capitalize the earnings at “twice the current interest rate on bonds”. Which is capitalize @ of twice the bond rate, not twice the multiplier. It is in fact half the multiplier of that of the bond.

    So if bond rate is 10%, the multiple is (1/2) * (1/10%) = 5 x

    Moreover, around 1940 when that edition was written, AAA rates were around 3.65% (see page 2 of SA). Halving that would give a ‘normal level’ yield for stocks of 1.83% and thus a P/E of 54 πŸ™‚

    Anyway, Graham would be unlikely to incorporate the ‘growth component’ in any but the most exceptional case. For him, incorporating growth into valuation was equivalent to having to rely on that future growth coming true for that component of the price paid to have proved justified. And Graham was complete anathema to betting any money on future growth.

    The relationship of the average stock’s multiple with that of the bond yield is quite an interesting one. More so as bond yields have tended to fluctuate quite widely over the decades. Infact Graham’s own views about this seem to have gone through changes.

    This is what he said in 1972 – β€œThe margin of safety is the difference between the percentage rate of the earnings on the stock at the price you pay for it and the rate of interest on bonds, and that margin of safety is the difference which would absorb unsatisfactory developments. At the time the 1965 edition of The Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks, and I say there is no margin of safety . . . you have a negative margin of safety on stocks . . .”

    The bond rate in 1971 was about 7.6%.

    So basically, in 1940 he said that fair value of the average stock lies at the price where they yield double the rate of a AAA bond. And in 1972 he was equating fair value of stocks at the price where they’re earnings yield was the same as that of the AAA bond.

  5. Taha,

    I have thought about it. And indeed the literal interpretation of the passage + the fact that 1/3.65% = 27X (hence, 1/2 of that = 13 is a more reasonable number than 2X of that = 54) is quite correct.

    But interest rates in India today (at 8% to 10%) are akin to the 1971 situation that you point out. Also note that in Appendix Notes 53 & 57 in SA, 1940 Graham talks in great detail about how the maximum multiple that can be given is around 20X.

    In this light a maximum multiple of 5X would be absurd. Under Indian conditions, frontline stocks logically deserve the maximum multiple that Graham himself would accord i.e. 20X.

    So yes, I did subconsciously go for the logical interpretation rather than the literal one.

  6. During the 1940s, when that edition of Security Analysis was written, the US had just passed through the Great Depression. Such a major economic convulsion what it did to both stock prices and stock values was enough to ensure that the stock buying public continued to have a significant negative bias towards stocks in general, well into the 1940s. This in turn ensured the average valuations accorded to stocks were low, or in other words, stocks in general were undervalued. It is in this background that Graham asserted the average stock’s fair value to be at a capitalization which was twice the yield of the AAA bond.

    By the 1970s (or maybe earlier than that), he realized that it would be an undervaluation to do so, and changed his fair value standards to capitalization at the AAA bond yield itself, instead of the earlier 2 times the bond yield. I think that is as far as one should go for valuing the average stock. The maximum multiple of 20X is for the exceptional company with considered to have exceptional prospects, to be used in the rarest of rare cases, and not for the average stock.

    Another point is that a frontline stock, and the stock of a secondary company, all else being equal, deserve exactly the same multiple (as they would logically have the same value to a private owner). The only difference is that the average valuation of a frontline stock as accorded by the market is usually close to what the value would be to a private owner, but for a secondary stock, average values are found to be much lower than the value would be to a private owner (the market habitually values it at a discount to that value). This would hardly mean that the valuation of the company itself would change depending on whether it is a primary or secondary company, but only that the quantum of ‘discount to value’ at which one should buy should be tweaked depending where one thinks the company lies on the spectrum of primary to secondary.

  7. Sachin Shetty

    I wanted to know how Warren Buffett and Rakesh Jhunjhunwala buy stocks? Using which medium they buy stocks? Do they use online services like Sharekhan? How do they manage their portfolio.

  8. Hi Sachin,

    They don’t exactly share the operational details of how they execute their buy and sell orders.

    With Warren Buffett, we can indirectly infer that he uses institutional brokers. Would probably be the same with Mr. Jhunjhunwala.

    The reason, of course, is the sheer size of their portfolios in value terms. Any meaningful addition deletion would require execution skills of someone on a terminal.

    For most of us retail investors, online brokers are good enough. If and when you attain the adequate size, there are plenty of options you can upgrade to. And trust me, most service providers would be happy to have your business.

  9. Earnings yield vs bond yield is being highlighted and the graham’s formula based on the thumb rule is quite interesting to arrive at approximate multiples. Thanks for the good article!

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