The Stock Component

I will start by outlining the criteria Graham ascribed to the intelligent investor:

(1) P/E. Price to earnings ratio should not be more than 10. A low P/E ratio is perhaps the simplest and most obvious indication that a stock is cheap- of course, a low P/E ratio alone is never enough reason to invest in a stock. Graham's insistence of a P/E ratio below 10 still stands as an indication that a stock might be cheap as the average for the FTSE 100 is around 13.

(2) Financial condition. (a) Current assets at least 1.5 x Current liabilities
  (b) Debt not more than 110% of net current assets. These criteria help exclude any companies that are in to poorer condition for the enterprising investor to consider.
 
(3) Earnings stability. No defecit in he last five years. It is still of maximum importance to the intelligent investor that he is buying into a profitable company.

(4) Dividend record. Some current dividend. The presence of a dividend is often underestimated today, yet in value investing it is essential. Just because you are buying undervalued shares, there is no reason why they may not remain undervalued for some time to come- a dividend gives an investor some income while he is waiting for a price rise.

(5) Earnings Growth. Some earnings growth over the past decade. Although hardly difficult to achieve, this criteria means any companies that are detracting are ignored.

(6) Price. Less than 120% of Net Tangible Assets. As well as indicating that the company might be cheap, it serves a double purpose, as a company with a large value for Net tangible assets per share is more likely to offer safety of principle that one that is trading on a high multiplier of its tangible assets.

Grahams recommended fields for the enterprising investor.

Graham recommends three aproaches that are likely to offer better than average returns over the long term, based on the principles that the stocks must meet objective tests of soundness, and the investing approach must be different from the policy followed by the crowd.

(1) Purchasing shares in unpopular Large companies. Graham argued that if the market overvalues popular "growth" stocks, then logically it will put a lesser price on companies "that are out of favour because of unsatisfactory developments of a temporary nature." Probably the best indicator of these shares is the P/E ratio, which of course should be combined with all other measures of financial soundness. Graham reccommends large companies upon the basis that they have the capital to carry themselves through adversity, and the market will respond quickly to any positive updates.

(2) Purchase of Bargain shares. Graham defines a bargain share as one which "on the basis of facts established by analysis, appears to be worth considerably more than it is selling for." He normally advocates paying not more than 2/3 of the true values for such companies, giving a large "margin of safety." Arguably his favourite criteria in the bargain section were those stocks selling at below their net-current-asset value per share- ie in buying £100's worth of shares, you owned more than £100 worth of current assets alone, effectively valuing the businesses fixed assets and future earnings at nothing. Of course these very occasions are rare indeed, but they do crop up from time to time.
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(3) Bargain secondary companies. Graham's third approach ties in somewhat with his second- he advocates that secondary (smaller) companies should not be purchased no more than 2/3 of their value. Of course amny investors are worried that their shares, if purchased at aan undervalued state, may remain that way in a "value trap". Graham cites 5 reasons why substantial profits from purchasing these companies arise:

(a) Dividend return is relatively high.
(b) Reinvested earnings are substantial compared to price paid and this will affect the price.
(c) Bull markets are normally more generous to low priced issues.
(d) Even during fairly flat markets, a continous process of price adjustment occurs.
(e) The factors that have created the undervaluation may well be replaced by new conditions.